Optimized Inventory Turnover: A Key to Profitability
The inventory turnover rate is an efficiency ratio used by inventory-driven businesses to determine the number of times during a period that the firm sells and replaces its inventory. An efficient inventory turnover rate can be a lead indicator of a firm’s profitability or alternatively show if there is cash tied up in inventory through overstocking, obsolescence or deficiencies in the product line or marketing efforts.
The most common and accurate formula used to determine a firm’s inventory turnover rate is:
· Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
For most retail and consumer goods businesses that use the “keystone” markup strategy, or double the cost to arrive at the selling price, the benchmark inventory turnover rate is 3x during a 12-month cycle. When controlled, variance from this benchmark should only occur when the cost of goods sold is low due to a high demand for the merchandise or greater than keystone markup strategy. Alternatively, if the turnover rate is low and the markup strategy is keystone, the firm may be suffering from high cost of goods and cash that is tied up in excess inventory.
The most effective ways to increase the inventory turnover ratio include:
· Analyze categories and sales history to eliminate slow moving product lines and order new inventory based on previous history and predictive analytics
· Identify dated or obsolete inventory and sell off quickly to recover cash
· Increase marketing efforts
With the exception of certain commodity items, consumer goods inventory depreciates over time, and if it sits long enough, the market will force prices lower- sometimes below original cost. When management is “married to the inventory,” failure to sell off the excess merchandise in good time, even at or below cost, will lead to a high cost of goods and little to no cash to reinvest in current or updated merchandise. If not corrected, the firm can quickly run out of cash and ultimately go out of business.
Optimal Inventory Turnover Rate
When used effectively, the optimal inventory turnover rate will identify the ideal turn rate to remain profitable prior to general and administrative expenses. A firm can benchmark the optimal turn rate against the actual turn rate to determine any variance and adjust markup strategies or identify the need to sell off excess merchandise if the optimal rate is too high to be economically feasible.
When the inventory turnover rate matches the optimal rate, it is an indication that:
· The ordering process is based on effective analysis of the mean in previous sales results
· The markup rate is leading to an economically marketable pricing of the goods
· The cost of goods sold reflects a positive net profit
· There is little to no pilferage or theft
Few ratios are more important to an inventory-driven business that the inventory turnover rate. When properly understood and controlled, management will have a greater understanding of where to make adjustments in overall strategy and ensure healthy cash flow.