As a manufacturing manager, you know that keeping inventory is costly. Warehouses are expensive to rent or own and inventory that doesn’t move takes up valuable space. That’s why inventory turnover is hands-down one of the top ten most important manufacturing KPIs. Manufacturers deal in inventory, whether that’s by storing raw materials, creating components, or selling finished products.
In this article, we’ll explain what inventory turnover means, how to calculate the inventory turnover ratio, and ways you can improve that number and boost your bottom line.
What Is Inventory Turnover in Manufacturing?
In manufacturing, inventory turnover is an important metric that tells you how often your stock of raw materials or finished goods is sold and replaced over your selected period of time (e.g. a month, a quarter, a year). In essence, it measures how efficient your production operations are and how effective your sales tactics are. If your inventory turnover is high, it means you’re moving goods quickly—great news for your bottom line. Conversely, a low inventory turnover suggests overstocking, obsolete products, or sluggish sales.
Understanding this metric is key to keeping your manufacturing process lean and your warehouse uncluttered. After all, holding onto inventory costs money, whether that’s in storage fees, insurance, or just the opportunity cost of capital tied up in unsold goods. So, the higher your inventory turnover, the more agile your business can be.
What Is The Inventory Turnover Ratio?
The inventory turnover ratio is a numerical expression of how many times a company’s inventory is sold and replaced during a specific period. Most companies calculate inventory turnover ratio by looking at the year to account for minor fluctuations that happen in shorter time periods. The inventory turnover ratio is calculated by dividing the cost of goods sold (COGS) by the average inventory for that period. This ratio gives you a snapshot of how efficiently your inventory is being managed.
A higher ratio indicates that you’re selling and replacing your inventory quickly, which usually points to strong sales and good inventory management. A lower ratio, however, can be a red flag, signaling that your inventory is stagnant or overstocked, often resulting in dead stock. Inventory turnover is an essential metric for both manufacturing and retail businesses, where managing inventory efficiently can make or break profitability.
3 Benefits of Understanding Your Inventory Turnover Ratio
- Optimized Inventory Levels: By knowing your inventory turnover ratio, you can fine-tune your stock levels to match your sales velocity. This means you have fewer resources tied up in unsold goods and more capital available for other business needs.
- Improved Cash Flow: A healthy inventory turnover ratio directly impacts your cash flow. The quicker you sell products, the faster you can reinvest in your business, pay down debts, or even expand your product lines.
- Enhanced Customer Satisfaction: Keeping inventory moving ensures that your products are fresh, up-to-date, and available when your customers want them. This can lead to better customer experiences and, ultimately, increased loyalty.
How to Calculate Inventory Turnover Ratio
Calculating your inventory turnover ratio is pretty straightforward. Here’s the formula:
Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory
To break it down:
- Cost of Goods Sold (COGS): This is the direct costs attributable to the production of the goods sold by your company.
- Average Inventory: This is typically calculated by adding the beginning and ending inventory for a period and dividing by two.
For example, if your COGS for the year is $1,000,000 and your average inventory is $250,000, your inventory turnover ratio would be:
Inventory Turnover Ratio = 1,000,000 / 250,000 = 4
This means your inventory was turned over four times during the year.
What the Inventory Turnover Ratio Tells You
Your inventory turnover ratio gives you insight into how well your team is managing your inventory. A high ratio generally means that your products are selling quickly. From this, you can deduce that your team is managing inventory well and that market demand is strong. However, if the ratio is too high, it could indicate that you’re not keeping enough inventory on hand, potentially leading to stockouts and missed sales opportunities.
On the other hand, a low inventory turnover ratio might indicate that you have too much inventory on hand, which can tie up capital and lead to high storage costs. It could also be a sign that your products are not selling as well as expected. If that’s the case, look into improving your product offerings and marketing strategies.
Your inventory turnover ratio is one clue to solving issues. It’s part of a greater whole.
Limitations of Inventory Turnover Ratio
While the inventory turnover ratio is a valuable metric, it does have its limitations:
- Doesn’t Account for Seasonal Variations: If your business is seasonal, your inventory turnover ratio might fluctuate significantly throughout the year, making it less reliable as a standalone metric.
- Not Always an Indicator of Profitability: A high inventory turnover ratio doesn’t necessarily mean you’re making a profit. It’s possible to have a high turnover ratio but still be selling at a low margin.
- Varies by Industry: Different industries have different benchmarks for what constitutes a good inventory turnover ratio. What’s considered high in one industry might be low in another.
Example of Inventory Turnover Ratio
Let’s say you run a company that manufactures electronic components. Over the past year, your company’s COGS totaled $2,000,000, and your average inventory was $500,000. Your inventory turnover ratio would be:
Inventory Turnover Ratio = 2,000,000 / 500,000 = 4
This means you turned over your inventory four times during the year. If the industry average is six, you should at ways to improve your inventory management or boost sales to increase your turnover ratio.
Is High Inventory Turnover Good or Bad?
A high inventory turnover ratio is generally seen as positive because it indicates that your products are selling quickly, which is a sign of strong demand and effective inventory management. However, if your turnover is too high, it could mean you’re not keeping enough inventory on hand, leading to stockouts and potential lost sales. It’s all about finding the right balance.
On the other hand, a low inventory turnover ratio suggests that products are sitting on shelves for too long, which can lead to increased holding costs, potential obsolescence, and reduced profitability.
How IIoT Software Can Help Manufacturers Improve Inventory Turnover Ratio
IIoT (Industrial Internet of Things) software is a game-changer when it comes to improving your inventory turnover ratio. By providing real-time data and analytics, IIoT solutions can help you track inventory levels more accurately, forecast demand more effectively, and streamline your supply chain.
For instance, IIoT devices like sensors can monitor stock levels in real-time, automatically triggering reorders when inventory drops below a certain threshold. This makes sure that you always have the right amount of stock on hand without overstocking or running out of critical components.
On top of that, IIoT software can analyze sales patterns and predict future demand, allowing you to adjust your production schedules and inventory levels accordingly. This not only helps improve your inventory turnover ratio but also reduces waste and increases overall efficiency.
Understanding and optimizing your inventory turnover ratio is crucial for maintaining a lean and efficient manufacturing operation. By leveraging IIoT technology, you can gain deeper insights into your inventory management processes, making it easier to keep your stock levels in check and your business running smoothly.
Ask Us How ProphecyIoT Can Help Your Manufacturing Business
At ProphecyIoT, we’re Industrial IoT experts. If you’re looking to streamline processes, minimize costs, and create more competitive business practices, contact us today to learn more.
