Have you ever wondered what the fuss is regarding the inventory turnover ratio? Why is it considered a pivotal statistic for a company? Let’s explore.
Inventory turnover ratio (ITR) is a benchmark that allows enterprises to realize the efficiency of their inventory management systems. Higher turnover ratios are viewed as positive and lower ratios are undesirable. Management and investors are interested in this ratio as it indicates how well a company is able to sell the inventory that it acquires in a given fiscal period. It is possible to increase the inventory turnover ratio and in this article, we’re going to examine six best practices on how to do just that.
What is Inventory Turnover Ratio?
First things first, how do you even calculate the inventory turnover ratio anyway? ITR is expressed mathematically as follows:
Inventory turnover ratio = Total sales / Average inventory
It is a ratio that lets you know how well inventory is being managed in your enterprise and is realized by dividing the sales against the average inventory over a given time period.
Alternatively, you can replace sales with the cost of goods sold. Dividing by the cost of goods sold is more accurate as this formula eliminates the markup that’s included in the cost price. Using sales means the inventory ratio is an inflated number that is not always representative. The average inventory is employed as this factors in the seasonal fluctuations of procuring raw materials and or products.
Understanding Inventory Turnover Ratio
What is the meaning of the ratio obtained when you calculate inventory turnover? In essence, preferred ratios are between 4 and 6. Low ratios suggest moderate sales and a high probability of excess inventory. Low ratios can also imply that you are stocking up on products that aren’t selling well or that your restocking process is slow. Whereas a high inventory turnover ratio is indicative of great sales, excellent cash flow, and healthy demand for your products.
Why it is Important to Understand Inventory Turnover Ratio
Managing inventory is an important aspect of any enterprise. Understanding the rate at which resources are consumed and replaced (inventory turnover ratio) can assist sourcing and procurement teams in better understanding:
- when to renew vendor contracts,
- how to price end-products,
- how to improve efficiency,
- how to mitigate sourcing costs and,
- how to improve manufacturing and marketing decisions.
With the benefits now clear let’s explore the best ways to increase this inventory turnover ratio.
1. Due Diligence
Benjamin Franklin’s aphorism, “A small leak will sink a great ship,” is a vital one in business. Because it is the seemingly small elements that you’re not aware of that can tank your enterprise. These leaks must be identified so they can be properly plugged and this is done when you carry out due diligence.
Due diligence includes sales forecasting which can be used to determine the important resources needed to create your best-selling products. Forecasting will allow you to identify the key raw materials required in manufacture.
2. Automated Systems
Automation is one of the leading inventory management tips any business could ever adopt. This is because it allows for real-time monitoring of products sold and tracks the current inventory stock. It removes the need to manually re-count stock providing you with a seamless way to check when stocks are low and need replenishing.
3. Negotiate Contracts Regularly
Nothing is as frustrating as slow-moving products sitting in storage waiting to be sold. Products that aren’t being bought fast enough means reduced cash flow. Don’t be hesitant in renegotiate your contracts with vendors and asking for more lenient payment terms. You may be surprised by the discounts you might be able to get if you only inquire.
4. Marketing and Sales
There is no denying the fact that when it comes to improving inventory turnover ratio, undoubtedly one of the best practices is to increase sales. A carefully curated marketing and sales strategy can go a long way in assisting in this regard. Such a plan should lead to a boost in overall sales and subsequently bring about higher inventory turnover.
5. Focus on Procurement
Procurement is an area that provides you with an opportunity to not only cut costs but also help grow your inventory turnover ratio. When purchasing raw materials and products ensure that you make use of Pareto’s 80:20 rule. Simply put, invest up to 20% in the products that bring in at least 80% of your profits margins. By cutting back on products that don’t sell well you will lower your turnover ratio.
6. Eliminate Excess Stock
Many enterprises are in the habit of buying safety stock to cover unforeseen incidents. However, this inevitably results in excess inventory which is not good for the turnover ratio. By improving forecasting during the due diligence process, you can buy exactly what you need so your surplus inventory is kept to a minimum.
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