Ecommerce Metric Refresher - Inventory turnover ratio
April 14, 2021
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Inventory turnover ratio is an ecommerce metric used to measure the number of times inventory is sold completely in a given time period.
In simple terms, it helps you understand how well are you turning your inventory into sales. It also enables you to pinpoint weaknesses in your inventory management, marketing campaigns, and merchandising techniques.
The following illustration shows the Inventory turnover ratio formula:
Let's see how to calculate Inventory turnover ratio with an example,
A company had sales of INR 51,44,000 in the year 2019, the inventory in the beginning of the year was 4,38,000, and the closing inventory is 4,43,000 with an annual COGS of 38,53,000.
Therefore, the inventory turnover ratio = 38,53,000 ÷ (4,43,000 + 4,38,000)/2 = 8.74
Now, let's see how many days it took for inventory to turn into sales, i.e. inventory days on hand (DOH). It is calculated by taking the inverse of the inventory turnover ratio multiplied by 365.
Therefore, its inventory days on hand (DOH) = (1 ÷ 8.74) x 365 = 41. 76 , i.e. 42 days
This means that this company has sold its entire inventory in 42 days.
Note: A higher inventory turnover ratio means you are selling goods quickly, and there is considerable demand for your products. On the other hand, a low inventory turnover ratio indicates weaker sales and declining demand for your products.
However, there are instances when a high inventory turnover ratio may not be good for your business. It could be due to offering heavy discounts in an attempt to clear inventory quickly because of poor inventory management, such as overstocking. These heavy discounts negatively impact your revenue as you have already incurred lots of costs on your inventory, including carrying costs and freight charges. Moreover, a high inventory turnover ratio could also result in a loss of sales, as there could be insufficient inventory to meet customer demand.
Why should businesses calculate inventory turnover ratio?
There are many reasons for businesses to calculate inventory turnover ratio, such as:
Determine in how much time inventory is sold over a period
Analyse blockage of working capital (inventory)
Predict and manage accurate inventory levels
Prevent high maintenance and carrying costs
Evaluate the risk of inventory becoming obsolete or expired
Implement an effective sales plan
Benefits of increasing inventory turnover ratio
More revenue, low costs A higher inventory turnover ratio means you're selling more products and generating greater revenue in a given period of time. As when inventory stays in your warehouse, it doesn't generate revenue but incurs costs— higher maintenance and carrying costs. The slower you'll clear your inventory, the higher these costs. For instance, with a higher inventory turnover ratio, you can store 3,000 units in a warehouse which can store 1,000 units at a time. How? By selling and replenishing your inventory quickly. This way, you can keep costs down and achieve higher profits.
Less wastage, better brand image Perishable products have expiration dates, such as food and beverage (F&B) and pharmaceuticals. You can't let them sit on warehouse shelves for long as they can get expired. However, even non-perishable products get worn out sitting too long in storage, such as electronics. They can start to look obsolete and, thus, cannot be shipped your the customers. In either case, it can lead to lost revenue for your business as you have to liquidate the stock. Because if you ship such products to your customers, it can hamper your credibility and brand image. Thus, having a higher inventory turnover ratio, you can ship fresh products to your customers and reduce your business's exposure to such risk.
How to increase inventory turnover ratio?
There are various strategies to increase inventory turnover ratio:
Work on demand forecasting Demand forecasting is the process of predicting customer demand using historical data and current trends to optimise inventory management. It will allow you to set standard inventory levels, which will help you prevent understocking and overstocking. Achieving this goal will enable you to increase your inventory turnover ratio as you stock up only what you require and sell your products during any season.
But how can you forecast so accurately?
Use a powerful inventory management system (IMS) With the right IMS, you can capture real-time data about each SKU (stock keeping unit) in your warehouse. It can help you examine historical trends of your sales, including your bestselling products, average daily orders, sales and returns during a period of time, and more. You can then combine these historical trends with current market situation and your upcoming major events, such as flash sales, to determine the optimum stock level you need to purchase.
Sell on multiple sales channels By selling on multiple sales channels like Amazon, Flipkart, Myntra, and more, you can expand your reach and tap into the largest customer base. This will enable you to attract more customers across sales channels, maximise sales opportunities and improve conversion rates. Thus, integrating with more channels will significantly improve your product visibility, enhance your sales velocity, and ultimately increase the inventory turnover ratio.
Turn to marketing and merchandising techniques A higher inventory turnover ratio is usually generated through selling. This means you need to invest some time and energy into marketing and merchandising techniques that can help you to attract customer attention. You can use email marketing to target your existing customers and attract new customers with incentives, coupons, and exciting offers. Moreover, you can create product kits, recommend upsells and cross-sells, and provide free shipping over a minimum threshold. It will enable you to achieve a higher inventory turnover ratio.
4. Get rid of excess inventory Excess old stock can drive down inventory turnover ratio, block revenue, and shoot up storage costs. If you are still struggling with excess old stock even after trying everything else, you can get rid of them. You can host clearance sales, run flash sales, offer unique discounts such as BOGO (buy one, get one), and more. These discounts may temporarily harm your profits, depending on their severity, make space for new inventory goods that sells faster, you may be able to recoup those losses.
One of the primary ways to achieve success in the ecommerce landscape is to turn your inventory into sales, that too fast. By calculating inventory turnover ratio and applying it, you can determine how many times you turn your inventory into sales. It will also give you more insight into your business, allow you to adjust your inventory levels, and help you liquidate the cash tied up in inventory. With revenue-oriented decisions and action-oriented steps, you can break even on slow-moving inventory, reduce carrying costs, and drive sales.