To ensure your small business is operating efficiently, effectively managing inventory and meeting customers’ needs, you should aim to improve inventory turnover. This, in turn, will help optimise business cash flow and maximise profits.
Inventory turnover is the number of times a business sells and replaces inventory within a specified timeframe. The inventory turnover ratio is used to determine the effectiveness of inventory control and how long a business takes to sell its on-hand inventory stock.
Inventory turnover ratio
The first task in establishing your inventory turnover ratio is to choose the timeframe to be measured, weekly, monthly or if necessary, in daily cycles. The ratio is then calculated dividing sales by the average inventory for this period.
The reason average inventory is used to calculate the ratio is to smooth the variables of any demand peaks and troughs of seasonality or you may only make stock purchase once or twice a year, selling throughout the year. An average inventory will accommodate for both situations.
To calculate your inventory turnover ratio, you simply add the beginning inventory for the period to the end inventory and divide by two: (beginning inventory + end inventory)/2
Alternately, the ratio can be calculated using the cost of goods sold (COGS). Generally seen as a more accurate measure of profitability because in addition to purchase price, it includes any carrying cost of goods sold such as conversion costs, overheads and any labour costs accrued within the defined period.
The COGS are subtracted from sales revenue to ascertain the businesses gross margins: (beginning inventory + inventory purchases) – end inventory
Under the perpetual accounting system, cost of goods sold is determined when a sale is made. In the periodic accounting system, cost of goods sold is not determined until the end of the accounting cycle.
Improving inventory turnover through proper inventory control can reduce the COGS, resulting in increased gross profits and more cash in the bank. Effectively providing SMEs with greater working capital because of the revenue generated by the inventory that is turning over at a regular rate.
Improve inventory turnover
Once you have determined your inventory turnover ratio your next step is to look at ways inventory turns can be improved. There are several areas where efficiencies can be made:
The better you are at forecasting what customers will want and when they will want it, the fewer goods you need to keep in stock and the higher your inventory turnover rate.
Put systems in place that will gather real information about what sells. Inventory software will collect sales information and can help to analyse past sales data to determine seasonal trends and provide better forecasting of future demand.
In addition to using historic sales data you should also undertake market research activities. Talk to your customers to gather informal information about their preferences and talk with sales staff to understand how customers interact with the items on your shelves.
If you are purchasing what your customers want, your inventory will turn over regularly, because your stock will sell, rather than sit on your shelves.
Sales and marketing
One way to improve your inventory turnover ratio is by increasing sales. This can be achieved through the formulation of smart marketing strategies that increase demand for your products and drive sales.
A targeted, well-designed and cost-appropriate marketing campaign should result in increased sales and inventory turnover. Marketing campaigns could focus on advertisements or promotional events and special offers and should be monitored and measured to ensure a successful return on investment.
Purchasing needs to be in line with demand. Using Pareto 80:20 principle, invest mainly in the 20 percent of products that reap 80 percent of the profit. Eliminate products with lower turnover ratios to improve the company’s overall inventory turnover.
Talk with your vendors to regularly review purchase prices and ask for discounts or price reduction when they are quoting for your inventory stock. This way you can reduce the cost of your inventory.
Explore any options available to minimise cost, options such as pre-paid shipping, extended credit and the inclusion of complimentary marketing materials for products.
Eliminate old stock
With a greater focus on improved forecasting techniques, you can reduce the need to invest in safety stock. Cut holding costs by disposing of old inventory stock through sales and mark-downs and invest the money in high turnover, faster-moving products.
Adopt a lean inventory strategy. With lower levels of on-hand stock you will turn over inventory more frequently. However, for this strategy to work, you will need to have a strong supply chain that can get items to you quickly to avoid the risk of running out.
Diversify product lines
Customers like a variety of options so offering new products or services can improve inventory turnover by creating a sense of urgency for customers to make an immediate purchase.
Purchasing these new items or new services helps keep customers interested in your business while potentially fulfilling another need they may have. Remembering to only stock products that sell quickly.
A healthy inventory is when you can maintain optimum stock levels for your business with minimal stockouts or surplus goods. Managed correctly, inventory turnover is a sign of a healthy business. By creating a picture of your inventory turnover you can observe what is working well and see where improvements can be made.