Achieve the Ideal Inventory Turnover Ratio for Your Business Goals
As a seller of a physical product, it is critical you understand how to manage your inventory.
Inventory management is not only about the materials and goods you have at any time. It is also important to consider the rate inventory comes into and leaves your workshop. The amount you sell in relation to your average inventory is your inventory turnover ratio.
It is a critical metric of business performance, yet many small manufacturers neglect this.
Knowing about your stock turns helps you to make decisions for your business.
It helps you answer questions like:
Am I keeping too much inventory at one time?
Am I selling enough?
Are my manufacturing costs too high?
Am I producing orders fast enough?
These questions go to the heart of inventory management and production flow. Therefore, you need to know how to calculate this metric. Your optimal turn rate depends on the size of your business and what you manufacture. In this article, we’ll help you learn how to interpret inventory turnover ratio and how to apply it to your manufacturing business.
What is Inventory Turnover Ratio?
The Inventory Turnover Ratio is how many times your company sells its inventory during a given period. The inventory number is not your maximum inventory, but your average inventory over this period.
Average inventory is the average value of your inventory. This includes raw materials and direct labor costs, like when calculating cost of goods sold.
Say you keep a constant stock of 10 items, and you sold 50 over a month. You would have turned over your inventory five times. Knowing this ratio helps you make decisions for your business.
Remember, sales revenue alone is not sufficient to gauge the success of a business. You could have sales revenues of millions of dollars, but if your expenses exceed this, then you’re in trouble. That’s why business guides stress the importance of knowing your costs at all times.
Why is Inventory Turnover Ratio Important?
It is a key measure of efficiency, as it calculates how much a business sells as a percentage of its total inventory.
Simply put, it tells you how much you sell as a ratio of what you keep in stock.
This ratio tells you how many times you fully replenish your stock in a time period such as a year.
For example, a company might have a huge average inventory, but relatively low sales. If it turns over its inventory only one or two times a year, can it justify having such large inventory levels?
Well the answer depends on several factors.
Large enterprises can afford to maintain a high average inventory because they sell a lot and / or they have the funds to offset the required costs.
It's an inventory strategy used by manufacturers that mass-produce goods every day.
This strategy is successful for large enterprises, so small businesses should seek to copy it, right?
Well, many people assume a small manufacturing business is just a scaled-down version of a large one. But this assumption could be detrimental to the business.
Small manufacturers usually produce more high-end goods. This means they use more expensive raw materials, with possible bespoke features. The mass production model is lacking when it comes to these kind of businesses, as they rely on higher margins for few products.
Enter lean manufacturing. Read on to find out why inventory turnover ratio is the missing piece of the puzzle.
If a small business keeps tons of stock in-waiting, then they could be losing money without realizing. The inventory turnover ratio can let them know if their workshop is inefficient.
Analyzing your inventory turnover allows you to scrutinize your business in a way you couldn’t do with the naked eye.
Are you stocking more inventory than you could ever need? Calculating your inventory turnover ratio lets you know about this.
When you understand this, we will show you ways to have lower inventory levels, while keeping your sales high.
How to Calculate Inventory Turnover Ratio
You can calculate this for your company using the inventory turnover ratio formula. This formula requires you to know two other financial metrics for your business:
Cost of Goods Sold (COGS); and
You can find out your COGS by checking your annual income statement or your inventory management software.
To calculate average inventory, find the value of your entire inventory at the beginning and end of the financial period. Again, the right software can help you keep accurate records of this. Once you have done this, add your beginning and ending inventory together. Divide by two (halve it) to get your average inventory.
Now plug the numbers into the inventory turnover ratio formula:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
So, if your company has a monthly average inventory of $5,000 and a COGS of $7,000 you will end up with an inventory turnover ratio of 1.4. That means you have turned over your inventory just under one and a half times in that time.
If you want to calculate the average time inventory is on hand for, divide your inventory turnover ratio by the number of days. For example, if you wanted to calculate this for October it would be:
31 / 1.4 = 22.14
This means you turned over your inventory once every 22 days or so.
Let’s try another example of inventory turnover ratio over the period of one year.
Say you are a high-end bicycle manufacturer:
You have a small boutique store with one bike of each model you produce. This lets you save loads of money and improve customer satisfaction by having bespoke requests. Customers come in and buy your bikes to order.
Each bike cost $1,400 to produce so you start off with $9,800 inventory in stock. Because you practice lean manufacturing, you have limited raw materials and MRO in stock, valued at a further $1,200. That’s a total starting inventory of $11,000.
By the end of the financial year, you have added two more models to your range. That plus raw materials comes to $12,900.
Average inventory = (11,000 + 12,900) / 2 = $11,950
Cost of goods sold comes to $87,000.
Inventory Turnover Ratio = 87,000 / 11,950 = 7.3
So, the value of average inventory was turned over 7.3 times.
To find out how many days it takes to turnover inventory once, divide the inventory turnover ratio by the number of days in a year, 365.25. This tells you this business took just over 50 days for one inventory turn.
What does inventory turnover ratio tell us?
Is the turnover in the previous example good or bad? Well, it depends on the goals and expectations of the business owner. That’s why this metric is so open to interpretation.
It’s up to you to determine if your inventory turnover is adequate for your business, but we can give you some general tips.
Understanding your industry is crucial when figuring out your ideal inventory turnover ratio.
This could vary greatly depending on if you only manufacture bespoke goods, or are in the food and drink industry, or make craft goods with low margins.
How Inventory Turnover Ratio Works in Manufacturing
Large manufacturers produce a lot and sell a lot. They can afford a “Make to stock” approach because they have a large budget and surefire demand. This is the key to not over-stretching yourself as a manufacturer.
If they keep in-depth historical records, then you can analyze them to make predictions about future demand.
For example, if a manufacturing company sold 50 to 100 items a month for the last year, then it might be reasonable to assume that this will continue. You could tell your shop floor to make 50 units to stock before these orders come in. In fact, this is how many larger manufacturing businesses work. If you manufacturer in bulk, this is a good strategy.
Manufacturers of less mainstream, bespoke, or custom goods may find their demand rises and falls more often.
There is a danger for small businesses keeping a lot of backup stock. If demand suddenly drops, then you have extra stock taking up space. They have costs tied up in them, and unfinished goods have labor costs that amounted to nothing.
Obsoleted stock takes time and money to get off your hand. this is not ideal for small manufacturers. If you had no use for them, you could try selling them at a reduced price to entice orders. But again, this eats into your margins.
We hope by now you see the benefits of not keeping a large average inventory. But what’s the alternative for small manufacturing businesses?
Many artisan or boutique business keep a very small number of demo items available on-premises. The majority of their inventory is created when they receive an order for it.
Large-scale manufacturers that mass-produce items tend to have high inventory turnover ratios because they have low margins. Therefore, they must manufacture and produce a lot of goods to become profitable. There may be some exceptions, but most follow this general rule.
Automobile manufacturers pump out a seemingly constant stream of cars. This is because they know the demand will be there. As the model gets more high-end, then of course not as many are manufactured. The manufacturer also takes more time on each unit.
Both a large-scale and small-scale manufacturer can have a high turnover. They just need to find the happy medium that works for them.
Consider the bike industry once again. There is an almost endless amount of bike sizes and styles available on the market.
The manufacturer producing bikes for Target and other large retailers has a constant production process. They produce bicycles from Monday to Friday at a speedy rate.
Contrast this with the artisan bicycle maker. They produce bicycles with high-quality materials to high-end specifications. If they produced bikes at 100% capacity, they would run themselves into the ground. That's why manufacturing to order puts far less stress on the small manufacturer.
This is a great example of how small manufacturers can compete with larger ones. Small businesses bring something to the table they do not — higher quality goods made with passion and skill.
How to Increase Inventory Turnover Ratio
Increase Demand for Inventory
If your sales revenue seems lackluster, then perhaps your sales are not high enough. You could have the leanest manufacturing process in the world, but if no one is buying your product, then you have problems.
The good news is that there are many ways to increase your sales. You could develop your company’s marketing efforts, for example. This doesn’t have to break the bank.
While you are generating interest in your products, find new sales channels to open. This could be starting with an e-commerce platform that suits your business. Of course, you can also find other ways to sell in the real-world, like getting spots at trade fairs or other events. This combined with online sales is a great way of developing a customer base.
Do you accurately place a value on not only your raw materials, but staff, and processing costs. If you have a high turnover, but low revenue, then perhaps you are not valuing your products highly enough. Do not undervalue your craftsmanship. Include all expenses and the profit margin in your final price. Let the customer know they are buying an artisan product, and show transparency in your production process.
By the same token, do not completely price out all potential customers. You have to find a happy medium. Increasing prices may lost some customers, but improve overall profitability. Just make sure your prices are a reasonable reflection of what you offer.
UK company Brompton charge many times more for one of their specialized bikes than a mass-produced one. They are targeting a specific audience base that are avid cyclists, and who are willing to pay for the best.
Cut Down on Costs
Finding areas where you are spending more than necessary can bring down COGS and average inventory. For example, for each square meter you use to store inventory has a cost as a percentage of the rent you pay to house it.
Inefficient manufacturing and shipping practices brings up your COGS, which eats into your profits.
Improve Time Management
Does your shop floor utilize every minute of every day to its full extent? Or are there chunks of wasted time littered throughout a typical working day? Take steps to optimize the time it takes your business to produce goods.
Increasing the efficiency of your workshop means that materials and goods spend less time providing zero value for your business (in storage or transit). Instead they are converted into revenue sooner, increasing your turnover.
Optimize Your Supply Chain
Is there a weak spot in your supply chain? Do you wait weeks for a supply order to come in to your shop floor. The increased lead times mean your manufacturing output is lower.
There's no need to buy everything in bulk. For items with low storage requirements like MRO, this is okay. But having raw materials and finished goods waiting around just serves to raise your average inventory, while doing nothing to increase sales.
Make to Order
The most obvious way to increase your inventory turnover is to make to order, not to stock. This means you keep a very limited amount of stock on hand at any one time.
This ensures that materials and effort are not wasted as they ship everything they make straight away.
That’s why this is the top way to increase your inventory turnover ratio. Your inventory will turnover will be much more agile.
Find Your Ideal Inventory Turnover Ratio
As discussed, your approach to your inventory turnover ratio depends on the size of your manufacturing business.
Small manufacturers should not strive to emulate their larger competitors. What is successful for a large business is not necessarily good for a small one. Conversely, many small manufacturing practices do not scale up to large manufacturing.
The question “What is a good inventory turnover ratio?” is not so simple. Like anything else, there is not a one-size-fits-all approach to the whole manufacturing industry. It depends on what you manufacture, and the size of your business.
Manufacturers of mainstream, mass-produced products have an abundance of software solutions, that handle everything from finances to supply orders to inventory management. These can cost tens of thousands of dollars a year to run because they need to be powerful enough for a large-scale business.
Spreadsheets are okay for displaying data, but they can never match the functionality of specialized software. The problem is that most solutions treat small manufacturers as a scaled-down version of their larger counterparts.
That’s why we’ve created Katana — The Smart Workshop Software as a solution that’s specifically tailored for the small manufacturer.
It is designed by experts in lean manufacturing to let you make to order without the stress of running out of stock.
You can improve your inventory turnover ratio with easy-to-use yet powerful metrics that are calculated automatically. All the facts and figures about your business are kept saved and up-to-date.
Make your inventory work for you. Katana prevents you from manufacturing goods for them just to sit around your workshop doing nothing.
Keep your production flowing and your inventory turnover high.