For an e-commerce business, inventory is one of the most significant parts of management. Inefficient inventory management can dramatically affect cash flow for your e-commerce business, with a large amount of working capital sucked up by the excess stock or sales lost due to stock shortages. That’s why keeping an eye on inventory turnover is key to ensuring flawless e-commerce business operations.
Let’s look in more detail at what a good inventory turnover ratio is, what can affect it, positively or negatively, and how to solve the most frequent inventory turnover challenges.
What is inventory turnover?
Inventory turnover is a financial ratio that defines how many times a company has sold and replaced inventory within an accounting period (a month or a year, or else). The metric helps determine the overall quality of the inventory management in a company and the efficiency at converting stock into sales. It also allows for identifying unused and obsolete stock.
Regularly monitoring the inventory turnover ratio gives a more accurate view of how timely goods are purchased and sold. This way, the company can build a balance in which the goods are never stale in the warehouse for a long time, but at the same time, they’re always in the required quantity.
A business with a higher inventory turnover ratio is likely to react better to the demand, have lower carrying costs per item, and gain more revenue than that with a low inventory turnover.
Let’s now see how to calculate the inventory turnover ratio.
How do you calculate inventory turnover ratio?
To calculate the inventory turnover ratio, you’ll need to define several metrics, such as the cost of goods sold (COGS) and average inventory. So let’s get acquainted with those first.
Cost of goods sold (COGS) is the cost of acquiring the products that an e-commerce company sells during a given period. So apart from pure costs per item, it may include freight and other expenses associated with getting the goods to your warehouse. To get your COGS, you’ll add the cost of purchased goods (including the associated costs) during a given period to your initial inventory for the same period and extract your ending inventory for this period.
COGS = Initial inventory + Additional inventory costs – Ending inventory
Manual calculation is no longer necessary since there’s a wide choice of automated solutions doing accounting for Shopify, Amazon, or any other e-commerce platform. So to find your COGS, you look through your income statement, and there it is. However, it’s good to know how to do it, which helps understand the metric deeper.
Average inventory is the mean value of inventory that a company holds over a given period (like a month, quarter, year, etc.). The simplified calculation (which in most cases is enough) will include the starting and ending indicators for the given period. The formula looks as follows:
Average Inventory = (Initial inventory + Ending inventory) / 2 (number of indicators)
A more sophisticated method takes the sum of more interim indicators (for example, values for each month within a year) and divides it by the number of these indicators.
Initial inventory is the value of the inventory at the beginning of a given period.
Ending inventory is the inventory value at the end of the same period.
Inventory at its cost is recorded and reported on a company’s balance sheet.
Inventory turnover ratio formula
Inventory turnover ratio = COGS ÷ Average inventory
The number you get will tell you how many times during the analyzed period you sold your inventory. But if you want to know how much time it takes you to sell it (usually called Days sales of inventory), you’ll need another inventory turnover formula, which is:
DSI = (Average Inventory ÷ COGS) x 365
Basically, both calculations show you the same thing, just from different angles. And knowing how long it usually takes you to turn your inventory into sales, you can plan for your future supply or, in case the ratio isn’t good, tweak your pricing and overall strategy to improve it.
What is a good inventory turnover ratio?
It brings us to a tricky question about what to consider a good turnover ratio for an e-commerce company because e-commerce embraces a variety of businesses. You can’t expect a consumer goods retailer to have inventory turnover similar to that, say, of a jewelry store.
This way, it’s not quite right to talk about something like an industry-wide standard ratio. So generally, we speak about a range of 2 to 6 (some name it 2 to 4) as indicative of a healthy business, showing that you most likely have enough inventory on hand and don’t need to reorder frequently. It’s commonly considered that the higher the ratio, the better a business is managed. However, a lot depends on what and how you sell and who your customers are. For example, for e-commerce businesses with higher profit margins that sell fewer but more expensive items, it’s more typical to have a lower annual inventory turnover ratio of 1 or 2.
So, how can you know what ratio fits the bill for you? The solution is to look around your niche and benchmark your inventory turnover ratio against what similar businesses have, giving you a clearer picture of whether you need to optimize.
How does having low or high inventory turnover affect your business?
Let’s now look at the drawbacks of inventory turnover being too low or too high and what causes it, and how it can affect your business.
The drawbacks of low inventory turnover
Low inventory turnover means that your items in stock are slow at moving through the business and sit on shelves for longer than intended. It can occur due to various reasons, of which we’ll talk about a little bit further. It’s critical to avoid low turnover, as its outcomes can seriously hamper your business. Here are the consequences that you may face:
Poor cash flow
Low inventory turnover often results in overstocking, which means a large piece of your money is tied up in stock that doesn’t sell. So you have less cash to spend on your business needs and opportunities.
As a result of overstocking, some items you failed to sell can get outdated and less or not demanded anymore. Often, it happens with seasonal goods or some expensive items. Such goods are called obsolete inventory, harming your business as you’ll need to sell them off much cheaper or write them totally off, which will impact your bottom line.
Higher carrying costs
Having a large stock sit on the shelves will inevitably increase your carrying costs. Those are all the expenses associated with holding inventory, including capital costs, storage space costs, and inventory service and risk costs. Add here the cost of lost opportunity (known as the opportunity cost), as items that remain unsold for a long time prevent the placement of new ones that may sell more readily. Altogether, they can eat away the profit margins for every item you sell.
Those are pretty unpleasant outcomes that restrain your business from growth and seriously damage your revenue. So, if you see that your inventory turnover ratio is low compared to what’s usual for your niche, you need to investigate what causes it and improve.
Among the factors that most frequently affect inventory turnover are wrong pricing strategies, seasonality, and poor inventory management procedures. Ultimately, there can be a lack of marketing, resulting in fewer sales and lowering the inventory turnover ratio.
The pitfalls of the highest inventory turnover
Previously, we mentioned that high inventory turnover typically speaks of good sales and healthy business. However, there are cases when high turnover can harm your business. Let’s look at the challenges you may face.
Often, businesses try to increase the inventory turnover ratio by diminishing the amount of inventory on hand to keep goods moving faster through the operation. This usually results in a limited choice of goods in terms of colors or sizes available. However, this way, merchants may endanger their sales by losing potential customers due to failing to meet their needs. Besides, there’s also a danger of not being able to refill the shelves in time to avoid the sold-out situations (especially when it comes to popular goods). Since customers don’t tend to wait for goods to be in stock again but instead search for what they need elsewhere, you might lose their business.
Higher operating costs
Businesses may purchase in small quantities to ensure inventory turnover is high. However, this can drastically increase operating costs: from higher shipping costs for smaller parties to the need to order more frequently and pay way more for the urgent delivery of out-of-stock items. Besides, buying large quantities in bulk often comes with volume discounts and special deals, which are not available for merchants that order a limited number of goods.
Increasing the turnover ratio by having less inventory on hand doesn’t necessarily mean that you’ll face trouble. It’s a pretty common practice, especially if a business is in its early stages of development. However, this will require more attention to inventory management and knowing the correct numbers to analyze. It’ll help you plan future supplies more accurately and escape unpredicted expenses that might eat up quite a chunk of your revenue.
How to improve inventory turnover: 4 actionable tips
So you see, inventory turnover is a dramatically significant indicator that you need to monitor and analyze and understand what to tweak to improve it. Efficiently managing inventory requires a strategic approach and well-built procedures. And here are some actionable tips that might help improve the inventory turnover ratio by boosting your sales and avoiding excess inventory.
1. Know your demand
Demand forecasting is one of the trickiest and most challenging things an e-commerce team faces. Wrong forecasting dramatically impacts your inventory turnover. It can result in either product shortages or cash tied up in the excess stock, and both are equally bad for your sales and revenue. So being accurate at predicting the demand helps you keep your stock at a healthy balance: enough to answer the demand and no need to reorder too frequently. Here are some best practices that can help you forecast demand more accurately.
Leverage your historical data. Data is your most valuable asset because it helps you see your business in real numbers and gives you plenty of insights into how you’re doing and what can be improved. Analyze and compare your previous years’ turnover for various groups of goods to define which remain to be on demand, which were trending but not anymore, or which sell only seasonally, etc. This way, based on the numbers, you’ll be able to plan your supply more accurately.
Know your best-sellers and worst-sellers. Putting together the data on sales for different products or groups of products, you’ll have a clear view of how they were selling in the past. Knowing what sells best, you’ll be able to plan for more products of this kind. And defining the worst-sellers, you’ll order fewer or no such products at all, thus preventing the situation when goods sit on shelves too long.
Provide for seasonality. There’s no secret that the demand for certain goods increases during certain seasons. Check your sales for the last few years and identify seasonality for various groups of products when demand is at its highest. This way, you’ll know when to order a large party to cover the seasonal demand and ensure the goods won’t remain unsold or become obsolete. Ultimately, you can profit from volume discounts suppliers often offer for ordering in bulk.
2. Improve inventory management procedures
As mentioned above, efficient inventory management is critical for e-commerce businesses as they have a significant amount of their working capital invested in the goods sitting in the warehouse. And the quicker they can convert this investment back into cash, the better. So apart from streamlining sales, they need to implement efficient inventory management practices to help move stock quicker through the business.
Optimize inventory. Inventory optimization is an ongoing task. It aims at having an ideal amount of inventory that is enough to answer the demand and won’t sit on shelves for too long. The best optimization practices include defining optimal inventory levels for different groups of products and also inventory categorization based on the ABC analysis. Let’s break it down. Having historical data on your sales and inventory turnover, you can define how many goods you need in stock for a certain period (like a month), so you won’t need to pay too much for the storage and won’t run out of goods unexpectedly. As for the categorization, it’s about classifying your products based on a certain parameter, like, for example, profitability. So a few items that make the most of your profit go to the A-class, those items that make a small part of your profit make the C-class, and B-class products are somewhere in-between. Such an optimization helps you set better replenishment rules for different classes of products, focus on your best-sellers, and prevent overstocking for the products with low turnover.
Set up ordering rules. Clear replenishment rules help you ensure you can fulfill orders, keep your customers satisfied, and don’t overpay for warehousing. Basically, they give those responsible for inventory a clear view of when they need to reorder particular products. When you have your inventory properly categorized, understand your optimal levels for various product groups, and have a data-driven demand forecast at hand, it’s much easier for you to define your reorder points. There’s a level of stock at which it’s necessary to place a new order with a supplier so that your remaining stock is enough to cover your customers’ needs before the next shipment arrives.
Go with automation. It’s a must for managing inventory efficiently. Putting together all the necessary data, you need to ensure it’s accurate. So you can’t go without inventory management software that can do this job for you. With so many offers on the market today, you’ll need to find the one that will meet your needs in the best way. Consider choosing a solution that will not only integrate data for you but also allow workflow automation. For example, send a new order to a supplier when you reach the set reorder point for a given group of products or send you a notification when reaching this point. You see the idea.
Clean slow and obsolete stock. As mentioned before, items that sit on shelves for too long are eating up your profit margins. So, to increase your overall turnover rate, you need to get rid of the excess stock. There are many ways to go about it, including putting them on sale or setting promotion prices for buying several pieces at once (something like buy 2 for the price of 1), redistributing the excess stock to a different location where demand for it is higher (if you have several storages in different locations). Ultimately, you can write off and destroy unsold goods (which is a worst-case scenario) or donate them to charity organizations.
3. Review your pricing strategy
You need to approach pricing wisely and be flexible to stay on top of the competition and drive sales. Regularly reviewing your pricing strategies can help you warm up the demand for products with slower turnover and help beat excess and obsolete stock. Here are some interesting pricing strategies.
Bulk pricing. With it, you help customers benefit from a better price based on the number of items they buy (something like 1 for $3, 2 for $5, 3 for $7, etc.).
Seasonal discounts. Sometimes, merchants that buy seasonal goods in bulk to have those volume discounts from suppliers can have too many items in stock by the end of the season. As the demand decreases, those items may go obsolete. So, it’s a kind of a common practice to go with a big sale when the season is over. However, a smarter approach implies starting with smaller discounts about halfway through the season and steadily increasing the price drops from there.
Bundle pricing. The idea of bundle pricing is pretty much the same as bulk pricing — to let customers have more with paying less. The difference is that you offer discounts for purchasing bundles of goods that might somehow complement each other. For example, you have one price for trousers, but if someone buys a pair of trousers, a shirt, and a belt, each item goes at a discounted price.
4. Improve customer experience
Customer experience is one of the critical drivers of sales and long-term loyalty. So for e-commerce businesses, it’s important to ensure that customers experience a flawless interaction at every step of the journey. It may require a thorough analysis of your sales channels to find and remove the bottlenecks. Here are some things you may want to consider.
Provide cross-channel experience. In the omnichannel sales world, it’s critical to provide customers with a unified experience across all the platforms and devices they’re using to interact with your business, including your overall messaging, offers, navigation, etc. Ensure that mobile and desktop versions of your store are equally informative and easy to navigate, products are easily searchable, or your checkout process is concise and provides a wide choice of payment methods across all your sales channels, etc.
Personalize your approach. Personalized product offers can help customers discover more products that might be interesting to them, which is highly likely to increase their order value and play in favor of a good experience. You might think about introducing additional sections to your product pages with similar or complementary products, or something like a “people who bought it also searched for” section, allowing you to up-sell or cross-sell more goods.
Be transparent. Being transparent about the products you sell, shipping, or other additional costs helps build trust and ensure your customers will come back to buy more from you. Moreover, providing the full information about your products (such as materials, dimensions, size charts, and more) helps drastically decrease the number of refunds. Customers will better understand what to expect and can make more informed buying decisions.
Engage more. The story shouldn’t come to an end after a customer has made a purchase. Returning customers are highly likely to buy from you again (and it’ll cost you less than acquiring new ones). Think about re-engaging with customers via email or social media campaigns with new arrivals, special offers, promos, or personal discounts. This way, you can encourage them to come and buy from you again.
The strategies above are not all that can help you improve your inventory turnover. They’re just the most common ones. And regarding your particular situation, you might see more opportunities. So the general idea is to monitor the demand first thing and act accordingly, tweaking your prices, doing more marketing, slowing down reordering of some products, etc.
Summing everything up, the inventory turnover ratio is a must-track metric for an e-commerce business. It shows how fast inventory is converted into sales, being one of the indicators of your business health. To understand whether your turnover ratio is good, you need to benchmark it against similar businesses in your niche. Many things can impact your inventory turnover ratio, but you can also influence it by boosting your sales and optimizing inventory management procedures.
Synder can help you put together all the necessary sales, products, or customer data from all your sales channels into accurate reports, so you can easily calculate your inventory turnover and have useful insights into how to improve it.