Keeping track of inventory is one of the most important things that you can do as a seller. You can have the best marketing in your niche and an endless supply of buyers, but that means nothing if you aren’t operating with a full understanding of what items you have, what items you need, and when to buy more. It’s absolutely critical.
To really take control of your own inventory, it’s key to calculate the inventory turnover ratio for your business. But a lot of new sellers don’t really understand this concept. What is inventory turnover ratio, and why is it so important? And what can sellers do to improve their understanding of their ratio?
Those are all questions that we are going to be going over in this article. Whether you’re new to the idea of inventory turnover ratio or you’re a veteran looking to refresh their knowledge, we’ve got you covered. We’ll start with the basics before going into some more advanced topics.
What is an inventory turnover ratio?
Okay, you probably now understand that you should know your inventory turnover ratio. But before we can talk about actually calculating this magical ratio, we need to establish what we’re talking about exactly.
Your inventory turnover ratio is basically a numerical expression of your sales versus your inventory. It essentially shows how quickly you are able to sell the items that you have. Once you actually calculate this ratio, you can do lots of things with it that will help you further determine the health of your business. But, at the very least, knowing the ratio is a good place to start.
While simply knowing how many items you have in your inventory is a great first step, that data is relatively meaningless if you don’t actually know how quickly you are selling what you have. Having 1000 items in inventory might be healthy for some sellers, but it also might be terrible for those that sell items incredibly slowly… or incredibly quickly.
In short, your inventory turnover ratio is a snapshot of your inventory and whether you are stocking items correctly. If you don’t know it, you may make mistakes that can really harm your business such as overstocking or understocking.
How do you calculate inventory turnover ratio?
Unlike many other things in the ecommerce world, the inventory turnover ratio is pretty standardized. No matter what you’re selling or how big you are, you’re going to use the same inventory turnover ratio formula as everyone else. The best thing about this formula is that it’s actually quite simple; you don’t need to be a math wiz to ace this one.
Without further ado, here’s the equation itself:
Total cost of goods sold in a certain time period / Average inventory value
That’s it! You just need to do a bit of simple division. Before you jump into it, though, you’ll need to do a few other steps to get ready to calculate your ratio.
The first is that you’ll need to determine what time period to use. Luckily, most companies will already be doing all of their accounting under monthly or yearly time spans, so you can just go with that. If you are basing your financial decisions by yearly figures, just choose that same period of a year.
Next, you’ll need to figure out the total cost of goods that you sold in that time period. Going with the previous example, let’s say that you sold $50,000 worth of goods last year. That data should be readily accessible for you (assuming you are doing your accounting correctly). That will be the number that you are going to divide by your average inventory value.
Before you do that, though, you need to find out your average inventory value. If you don’t already know this figure, it can be slightly tricky to find it. Your average inventory value is an important number to know, though, so definitely make an effort to make it as accurate as possible. For our example, let’s just say that you usually have about $10,000 worth of goods in inventory at all times.
That means that your two numbers are $50,000 and $10,000. You divide $50,000 by $10,000, and voila! You have your inventory turnover ratio of 5.
What’s a good inventory turnover ratio?
There’s no point to just calculating your inventory turnover ratio unless you actually want to learn from it. Luckily, it has a lot to say!
Let’s refer back to the example above. The inventory turnover ratio ended up being 5. That means that you sold your entire inventory and restocked five times within the given time period (which, in the example, was a year long period). That’s a great thing to know!
But still, is that ratio of 5 a good thing or a bad thing? Ultimately, the answer depends on the industry that you’re in. An inventory turnover ratio of around 2 to 4 is generally accepted as being solid, but the range of acceptable ratios will vastly depend on whether you’re in a fast or slow niche. Check with other sellers or do some research about your market to see whether your inventory turnover ratio is too high or too low.
What does a high inventory turnover ratio mean?
If your inventory turnover ratio is higher than it should be within your industry, it means that you are restocking your inventory more often than you should be. It also means that you are selling a lot – which is good – but that you aren’t stocking appropriately in response to your high sales.
There are a lot of ways that you can respond to this. The most obvious solution, of course, is to simply operate with a larger average inventory. This will save you money on shipping costs and labor required to constantly buy new items and refill your inventory as it sells out again and again throughout the year.
If you don’t have the funds to have a larger average inventory, though, there are other steps you can take to mitigate your inventory turnover ratio. You can start to limit sales; you can increase the prices of your goods; you can “sell out” quicker. It’s really up to you how you want to go about fixing it.
Additionally, having a large inventory turnover ratio isn’t a death sentence. If you feel that what you are doing is working for you, you don’t need to change it. Just think of your inventory turnover ratio as an indicator of how well you are managing your inventory. It’s not a strict rule that needs to be followed.
What does a low inventory turnover ratio mean?
Having a low inventory turnover ratio means the exact opposite of a high ratio. It means that you are not selling much – or that you are buying too many items.
Think of it this way. If your average inventory value is $100,000 and you sold $100,000 worth of goods last year, that means that you have an inventory turnover ratio of 1. That means that you need to restock once a year. On the surface, that doesn’t sound like a huge deal. But it can actually be pretty costly.
If you only sell $100,000 worth of goods a year but operate with an inventory of the same size, that means that you are paying to store a much larger number of items than you actually need to. While cutting down on shipping costs with fewer restocks can be good, you also need to consider all of the other logistical costs that go into a low inventory turnover ratio.
Luckily, the solution to a low turnover ratio is actually not too difficult. Just buy less inventory and buy more often! Of course, changes like this aren’t always as simple as they sound, so you may need to work with vendors and shipping companies to make sure that these changes are in your financial favor. Still, you don’t need to do a lot of calculations or serious overhaul to raise your inventory turnover ratio and make it better.
And just like having a high inventory turnover ratio, having a low one isn’t something that you immediately need to fix. Find out what kind of inventory turnover ratio works best for you and just go with that.
Optimizing your inventory turnover ratio
Aiming for a ratio between 2 and 4 is a nice rule of thumb, but how can you really find the perfect inventory turnover ratio for your unique business?
The first thing that you should do is really do some great research into your particular niche. For instance, luxury goods shops are naturally going to have a lower turnover ratio than other shops because their items are so expensive and are only rarely sold. That’s not a bad thing – that’s just the nature of that niche! A diamond shop might have a ratio of 1, but that’s nothing to worry about. Researching your industry will help you understand what your ratio should be – and more importantly, why it should be that number.
There are lots of tools online that can help you research what your inventory turnover ratio should be within your niche. Websites like ReadyRatios.com let you look at different industries, and you can even break down the data by year. That means that you can see if the inventory turnover ratios are trending in a certain direction. This is key because staying on top of trends is always paramount for sellers.
Another step you can take to optimize your inventory turnover ratio is investing into detailed demand forecasting. Having the correct ratio based on past data is one thing, but how much inventory you buy will ultimately depend on how much your customers will buy in the future. There are sadly no crystal balls in the ecommerce world, so demand forecasting is the closest you can get to looking into the future. Try to plan to have the best inventory turnover ratio for the future by accurately seeing what the demand will be like as time moves forward.
Demand forecasting isn’t always easy, though. There are a lot of factors to consider when doing it: seasonality, year-by-year trends, the growth of your business, and the growth of your niche should all be considered. If you don’t have a lot of experience with it, consider bringing in an outside analyst to offer their expertise. Having someone who really knows about demand forecasting can make a huge difference in how accurate your predictions really are.
The importance of inventory management software
Calculating your inventory turnover ratio is highly dependent on how well you actually know your inventory. This isn’t a big challenge for smaller stores, but it can be really tricky as shops get bigger and bigger. If you’re using a big warehouse that isn’t near you physically, it can be difficult to maintain a good understanding of what goods you actually have and don’t have.
Back in the day, this was solved by just using very accurate accounting on paper. But technology has saved the day! There is now a lot of innovative software out there that can help you manage your inventory. While it can be a change for some business owners to shift over to a digital solution to inventory management, it’s critical for success in the modern age.
Not only will a solid and reliable piece of inventory management software help you accurately determine your inventory turnover ratio, it will also help make sure that you don’t waste money on overstocking mistakes and unnecessary shipments. Inventory management software will also help you dodge running out of stock unexpectedly, which is every seller’s worst nightmare.
Inventory management software recommendations
Lots of sellers aren’t sure where to start when deciding on inventory management software. To help you out, here’s a quick overview of a few common pieces of software that are used by some of the most successful online sellers.
Cin7 is not only one of the highest-rated pieces of inventory management software out there, but it’s also an affordable option for businesses that aren’t quite established yet. They offer several different pricing models that you can select from depending on the size of your business. Their small business package is only $299 a month, making it very accessible for new sellers. As your shop grows, you can upgrade to their advanced package – or even their enterprise package.
Katana is another popular option. Their software lets you do all of your management in real time, watching your products from the warehouse floor all the way to the point where they end up on your customers’ doorsteps. Many prefer Katana because of the fact that it lets you manage tasks both small and large. It also integrates well with many common ecommerce platforms like Shopify and WooCommerce.
NetSuite is one of the most trusted names in the inventory management world, and their company has been around since 1998. Their inventory management software is regularly rated highly by ecommerce sellers, and it has been known to help reduce logistical costs for many businesses. While their pricing depends on the size of your business, it is generally considered relatively affordable.
Working with a 3PL
Much of what we have discussed thus far is for shop owners who prefer to be more hands on with their businesses. But what about those that would prefer to spend a bit more money to make sure that everything is taken care of for them by experts? That’s where a 3PL comes in.
3PL stands for third-party logistics. This refers to a company that handles issues for you when you feel that you no longer can. They can handle every aspect of order fulfillment, and it has become more and more accepted for ecommerce businesses to trust 3PLs with many things that they used to manage themselves.
There are tons of benefits of working with a 3PL. For one, you will no longer need to worry about keeping track of your inventory and calculating your own inventory turnover ratio. Many will also provide you with regular reports that contain data and analytics that will help you make important business decisions in the future. Another benefit is that 3PLs will ensure that you reorder inventory at the right time – you’ll never have a silly human error that makes orders late again.
3PLs certainly aren’t for every online seller, though. For many shops, the costs of partnering with a 3PL just don’t make sense. If you’re still small and don’t yet find that managing your inventory is too costly or time-consuming, you may as well just continue doing it yourself. Medium-sized shops can also just consider hiring a few individuals to manage inventory-related issues rather than paying to work with a 3PL.
Still, you really can’t beat the convenience that a 3PL can bring you.
Tricks for fixing low inventory turnover ratios
If you do feel like handling everything yourself, though, there are a lot of tricks that you can use to your advantage to help fix a low inventory turnover ratio. If you don’t yet feel like adopting a completely new business model, trying out one of these tips can help you move your inventory turnover ratio in the right direction without any massive adjustments.
Our first tip is to try out creative promotions to help increase the rate of inventory turnover. If the issue is that you are simply not selling enough, a clever new marketing ploy can really help more products move out of your warehouse and into the homes of your customers. Regular discounts and sales will make your sales increase, and your inventory turnover ratio will go up as a result.
Another great trick that can be used to sell more is to try out product bundles. Find related products and offer them together for a discounted rate. Customers that would have normally only bought one item might be convinced to buy two if you give them a compelling reason to do so. We would recommend looking at your sales data to really determine what products would go best together.
Many businesses also employ pre-orders to help deal with a low inventory turnover ratio. Pre-orders will not only help you sell more items, but they will also give you advanced data on what kind of excitement there is out there for your product. There aren’t many more accurate methods of forecasting product demand than offering pre-orders! To help increase excitement, you can give out bonuses or discounts to those who opt to pre-order an item rather than buying it once it’s already out.
Finally, another strategy to improve a low turnover ratio is to alter your pricing. While this can be seen as a drastic solution, it’s still less intense than modifying how many items you are ordering. Experiment to see what prices are most profitable for you while still moving more items off of your shelves. You might be surprised that a small change can make your shop more appealing, thus fixing your inventory turnover ratio problems.
Don’t let the seasons sneak up on you
There are many issues that can cause your inventory turnover ratio to skew too high or too low. One of the most common is seasonality. Buyers naturally spend more or less based on what season it is, and that can be amplified if you sell a product that is more relevant or exciting depending on the season.
For instance, customers are always more likely to buy items during the holiday season. That goes for almost all industries. But these effects can be even more true if you sell something that is often given as a gift. Seasonality can also be somewhat mitigated by selling something that is less relevant during the high buying season. Swimsuit shops don’t see as big of booms during Christmas as wrapping paper shops.
Similarly, you might find that there are just some times during the year where your products don’t sell very well. No one wants to buy space heaters in the middle of the summer. Even though that’s not an established low or high buying season, it matters a lot to your particular shop.
This is all to say that demand and purchasing activity swing a lot depending on the season. And that can really change how much inventory you stock. If you just stock things like you regularly do, you’ll end up having an inventory that is too small or too large. And that can really impact your inventory turnover ratio.
If you plan your inventory around the idea that you will be selling $8000 worth of goods, you might get really caught off guard if you suddenly sell $20,000 during Christmas. You’ll need to drastically alter how much you restock because of this. Restocking four times during the holiday season doesn’t mean that you will always need to buy that much inventory during other months, though.
In short, the last thing that you want is for the seasons to cause you to make poor inventory decisions. But they don’t have to catch you off guard. Look at your historic sales data as well as general sales data within your market. If you notice large changes in certain months, plan ahead for that. This will help you control your own inventory turnover ratio and not make yearly decisions based on seasonal trends.
Consider new vendors or shipping companies
Ecommerce comes with a lot of tricky logistics, and all of them can contribute to a wonky inventory turnover ratio. But sometimes your ratio being too high or low isn’t your fault. It can sometimes be the fault of other companies that you are working with.
If you find that you are needing to restock your inventory far more frequently than you should be, it may be because your vendor simply isn’t shipping items to you quickly enough. If you are constantly waiting for your items to actually arrive, it will make it seem like your inventory is always low. These long wait times can make it seem like there’s an internal problem when it might actually be external.
In a similar vein, it’s also important to take a look at the shipping companies that you are working with. If they aren’t moving items out of your warehouses quickly enough, it might seem like you have way too much inventory in stock. This might cause you to find ways to increase sales – or even order more. But if it’s actually an issue with products not being shipped out quickly enough, it may not be your fault at all.
For these reasons, one major part of analyzing your inventory turnover ratio should be analyzing your vendors and shippers. Look at your wait times and compare them with those offered from other companies. Can you make things more efficient? If so, it may be worth changing who you work with.
Invest in marketing tools
Sometimes a low inventory turnover ratio is just an unfortunate sign that your business isn’t doing as well as it could. But don’t despair if that’s true: that simply means that there’s a big opportunity for growth and development within your company. Even if that’s the case, though, the question remains: how do you fix the low inventory turnover ratio? What steps should you take to make your business more effective?
The answer to that question will ultimately depend on your unique situation. But if you are simply looking to sell more items, we strongly recommend turning your focus towards marketing. Marketing is everything in the modern age of ecommerce, and investing in it can make a massive difference in how often you are turning over your inventory.
There are lots of marketing changes that you can do relatively easily. If you’re already spending money on Google Ads, change how much you’re investing into that. If you haven’t partnered up with social media influencers, consider doing that. You don’t need to reinvent the wheel here: just try to get your products in front of more eyes.
But if you’re still feeling like you’re not sure what to do, there are online tools that can really help reinvent the marketing of your shop. If you’re selling on Shopify, you can even just go to the Shopify App Store to find tools that will give you the helping hand that you need. Many of them are relatively cheap too.
Finally, you can always look into hiring a marketing expert to help reshape your brand. While some marketing decisions are common sense, having someone who really knows their stuff can have a major impact.
Pursue more funding
If you’re still lost on what to do to really optimize your inventory turnover ratio, it may be because you just simply don’t have the funds to make the business changes that you should. That’s not a fun realization. However, it’s still not a reason to throw in the towel. If money is the issue, there are lots of ways to get more cash for your online shop!
If you’re trying to find funds quickly, there are plenty of online services that offer small loans to shops based on their credit and/or business performance. While these tools rarely give the largest loans out, they sometimes will be able to get money to you in just a few days. If you’re really desperate to make some changes to fix your ratio, this is probably the best path for you.
If you don’t mind waiting for a bit, though, there’s nothing wrong with going for a good ol’ fashioned business loan from a bank. These take a long time, but the benefits are huge. You’ll usually get more money – and have a smaller interest rate – than by going with any other source of funding.
And if all else fails, a crowdfunding campaign is a great way of obtaining funding – and publicity. If it goes well, you’ll get your shop in front of way more eyes. Just beware of competitors looking to steal ideas if you share a detailed description of your business model.
