This post is by Fabricio Miranda of Flieber.
Retail is a money machine where you turn capital into inventory, and inventory into sales. The more times you run this machine, the more profit you generate.
Let’s say you start the year with $1 of capital that you take and invest in inventory. You sell that inventory and make a profit of $1, so now you have $2. Repeat that cycle, and reinvest your $2 in more inventory, to generate sales of $4.
If you can do this three times in a year (typical for an Amazon private label seller), you will fit in one more cycle and end the year with $8. That’s made up of the original $1 you invested, plus $7 in profit.
Now, if you can shorten your cycle times and squeeze four cycles into a year, you will come out with $16 instead. Just by improving the rate at which you move your inventory, you have $15 in profits rather than $8.
It’s a simplistic example, but it illustrates a point. You should always want to sell products faster, with the lowest possible inventory on hand, and the lowest possible capital invested in that inventory. The way you can do that is by using three simple inventory metrics: inventory turnover ratio, inventory-to-sales ratio, and inventory sell-through rate. Here’s how they work, and how to use them in your business.
What are inventory management metrics?
Inventory management metrics are indicators that help you monitor inventory and make decisions about your stock. They influence how often you order inventory, how many units you order, which products you make a priority, and which products you might discontinue or scale back.
We have chosen three metrics which we think are a very good combination for online retailers. Other inventory metrics exist, and can have a role to play, but we feel the best starting point is:
- Inventory turnover ratio: the number of times your inventory is sold and replaced. This tells you how quickly you are moving stock through the business.
- Inventory-to-sales ratio: the relative amount spent on inventory to produce your sales. This tells you how efficiently you are investing in inventory to generate sales.
- Inventory sell-through rate: the percentage of inventory received that is successfully sold. This tells you how quickly you are selling your stock.
Inventory turnover ratio and inventory-to-sales ratio are usually annual metrics, and inventory sell-through rate is typically calculated on a monthly basis.
These metrics provide an overall picture of your inventory health. Once you know them, you have a baseline that you can monitor. This helps avoid stock-outs and excess inventory, shows the impact of higher costs, and helps you prioritize the most profitable products.
As you make changes to how you manage your purchasing, product selection, pricing and marketing, these metrics will change, showing you clearly if things are improving or declining. Without them, you are working in the dark and risk making decisions that move your business in the wrong direction.
What is inventory turnover ratio?
Your inventory turnover ratio shows how many times inventory was repeatedly sold and replaced over a period of time, usually a year.
The ratio is calculated from the cost of inventory, but let’s look at an example based on units to make it simpler. If you sold 200 units in the year, and had 100 units in stock on average, your inventory turnover ratio was 2. You might also hear people say that they “turned over” their inventory twice or that they had two “inventory turns”. They all mean the same thing.
Of course, you can’t sell the same stock more than once. To achieve an inventory turnover ratio of more than one, you will need to have bought more stock during the year, probably on multiple occasions.
The general idea is that a higher inventory turnover ratio is better. It means you are ordering regularly and moving stock through the business quickly, rather than purchasing a huge pile of stock that takes up space and shrinks down slowly.
On the other hand, a really high inventory turnover ratio might not be good either. It could indicate that you are ordering too often and letting stocks run too low. This risks stock-outs that cause lost sales and create gaps in your sales history, negatively impacting your search ranking on marketplaces like Amazon and eBay.
Note that as inventory turnover is based on the cost of inventory, it does not take sales or profit into account. It’s a good idea to use it alongside other metrics to get a more nuanced picture. If you only focus on moving inventory quickly, and not on the profitability of that inventory, you could put in a lot of work selling products that produce little return.
How do you calculate inventory turnover ratio?
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory Value
Let’s break the formula down:
Cost of goods sold (COGS) is the total cost of products sold during the period being analyzed. It covers all the costs of getting products into stock. For online sellers, who outsource manufacturing or buy from wholesalers, that includes the purchase price plus inspection services, freight shipping, import duties etc.
Average inventory value is the average between the cost of inventory held at the beginning of the period being analyzed, and the cost of inventory held at the end of the period being analyzed. All the costs should be included, as for the COGS.
Note that the cost of goods sold (COGS) part of the formula is for products sold, but based on the total cost to you of purchasing those items. You will need to be able to run a report on the products that were sold during the period (usually a year) and see how much it cost you to purchase them. This is not as easy as simply finding your total sales.
Let’s look at an example.
Company Alpha made sales of $1.2 million last year, and the total amount they paid to get those items into stock was $400,000. Alpha’s cost of goods in inventory was $120,000 at the beginning of the year, and $80,000 at the end of the year, giving an average inventory value of $100,000.
Using the formula above:
Inventory Turnover Ratio = $400,000 / $100,000 = 4
Therefore Company Alpha’s inventory turnover ratio for the year was four. The business turned over its inventory four times in the year, or every three months on average.
What is a good inventory turnover ratio?
The optimal inventory turnover ratio depends on your particular business and inventory strategy.
Some companies have complex supply chains, with components being ordered from different suppliers around the world, which need to be combined and packaged to create the finished product. Other companies have very unpredictable sales from one month to the next.
These kinds of businesses might have turnover ratios in the 3 to 6 range. This reflects that they will hold a relatively high amount of stock to provide a buffer against supply delays or sudden changes in demand.
In contrast, companies with local suppliers and steady sales can be much more aggressive with their inventory strategy. They might maintain a very high inventory turnover ratio of 10 to 15, meaning they need less storage space and have less capital tied up in stock. The downside is that they have very little buffer to protect them against supply issues or sudden changes in sales velocity.
On the whole, businesses should aim to keep their inventory turnover ratio as high as possible, while being realistic about potential supply issues and the reliability of their sales forecasts. A higher inventory turnover ratio means that less capital is being used to run the business, so less debt or investment is needed just to keep things going.
Another reason to keep inventory levels low is that it reduces the risk of holding obsolete or expired products. That kind of excess inventory, with low or zero sales potential, ties up capital and takes up valuable space. Minimizing the amount of inventory that can “go bad” means that more resources are available to respond quickly to market trends and new product developments.
What is inventory-to-sales ratio?
Your inventory-to-sales ratio shows how much money you are investing in inventory to generate your sales over a period of time, usually a year.
Like the inventory turnover ratio, the formula uses your average inventory value, as you will see in the next section. But instead of comparing it to the cost of goods sold, it compares it to the selling price of goods sold. This means that instead of just telling you how fast inventory is moving, it shows how hard your capital is working to generate sales.
The inventory-to-sales ratio works in the opposite direction to the inventory turnover ratio, so a lower number is better. For example, an inventory-to-sales ratio of 1 would mean that every dollar invested in inventory is producing only 1 dollar of sales each year. This shows that capital is being tied up in inventory that isn’t selling and the business is likely to be in trouble.
Conversely, an inventory-to-sales ratio of 0.1 would mean that every 10 cents invested in inventory is generating 1 dollar of sales each year. This is a much healthier ratio and shows the business is making better use of its capital. The lower the inventory-to-sales ratio gets, the less capital the business needs to generate the same amount of sales.
While the inventory turnover ratio is very useful to understand how many times you churn your inventory during the period analyzed, the inventory-to-sales ratio is used to understand how efficient you are in allocating capital to your inventory.
Overall, businesses want to keep their inventory-to-sales ratio as low as possible. A low ratio results in higher profit margins and lower operational risks – if something goes wrong, the potential losses are much lower when you are carrying less inventory. But just like the inventory turnover ratio, a practical approach needs to be taken to allow for supply constraints and spikes in demand.
How do you calculate your inventory-to-sales ratio?
Inventory-to-Sales Ratio = Average Inventory Value / Net Sales
Let’s break the formula down:
Average inventory value is the average between the cost of inventory held at the beginning of the period being analyzed, and the cost of inventory held at the end of the period being analyzed. All the costs should be included, just as with COGS.
Net sales is your total gross sales for the period, minus any returns, allowances or discounts. Basically, it’s the total amount your customers paid you, less any refunds you paid them back.
Some sellers find the inventory-to-sales ratio easier to calculate than the inventory turnover ratio. That is because it uses the cost to you of the stock you are holding, and the selling price of the sales you made. You probably need to keep track of your current inventory value anyway, for insurance purposes, and it’s usually straightforward to run a report on sales.
Let’s look at an example.
As above, Company Alpha’s cost of goods in inventory was $120,000 at the beginning of the year, and $80,000 at the end of the year, giving an average inventory value of $100,000. Alpha made sales of $1.2 million. It had $200,000 of returns, allowances and discounts, giving net sales of $1 million.
Using the formula above:
Inventory-to-Sales Ratio = $100,000 / $1,000,000 = 0.1
Company’s Alpha’s inventory-to-sales ratio for the year is 0.1. For this period, Alpha had to invest 10 cents in inventory to generate every 1 dollar in sales.
What is inventory sell-through rate?
Your inventory sell-through rate shows the amount of inventory sold within a period, relative to the amount of inventory you had at the start of that period. It is often calculated on a monthly basis.
The inventory sell-through rate illustrates how quickly you are selling your products. A rate of 50% means that you sold half the units that you had at the start of the month.
Looking at the sell-through rate over time is often very useful. If the rate is steadily increasing, then your sales are improving. But if the sell-through rate increases too fast then your inventory levels will decline and you risk running out of stock.
While the inventory turnover ratio and the inventory-to-sales ratio measure the overall efficiency of your inventory, the sell-through rate is often used to measure the performance of individual products. This makes it a portfolio analysis tool, so you can identify your top and bottom performers.
Products with a low sell-through rate are selling slowly, and if you don’t adjust your ordering to match then you will start to accumulate stock. To move the rate up and stabilize your inventory levels, you might want to reduce your reorder quantity, decrease pricing or run promotions. By taking actions to limit supply or boost demand, you can bring them back into balance and improve the sell-through rate.
Products with a high sell-through rate are selling quickly. That’s good, but if sales get ahead of restocking then your inventory levels will start falling. This might be intentional, to improve inventory turnover and reduce the amount of capital tied up in your stock.
On the other hand, it might be a sign that demand has increased unexpectedly, or it has become difficult to replenish your stock. You could look for alternative suppliers, increase pricing or scale back promotions to address this. It’s always a good idea to maximize the value you can get from your inventory (and the capital invested in it) and avoid going out of stock.
Note that if you receive new supplies infrequently, such as quarterly, then a monthly sell-through rate will drop dramatically after new stock arrives, and give a misleading impression. In this case, it might work better to calculate the sell-through rate over a three-month period.
How do you calculate your inventory sell-through rate?
Sell-Through Rate = Units Sold / Beginning Inventory x 100
Let’s break the formula down:
Units sold is the number of units that were sold during the period being analyzed.
Beginning inventory is the number of units held in inventory at the start of the same period.
Let’s look at an example.
Company Alpha holds 1,000 units of its top-selling product Romeo at the beginning of the month, then sells 250 units over the course of the month.
Using the formula above:
Sell-Through Rate = 250 / 1000 x 100
Company Alpha’s sell-through rate for Romeo is 25%. This means that Alpha was able to sell 25% of its stock of Romeo during the month.
Note: some companies calculate the sell-through rate as the number of units sold divided by the number of units received from suppliers during a given period, rather than the number of units held at the beginning of the period. That method does not take inventory levels into account and gives a different result to the one used here, so the two versions must not be mixed.
How should I use the different inventory metrics?
All of these metrics are more useful when you track them over time.
Simply knowing that your inventory turnover ratio is 4, for example, does not mean a great deal on its own. To make better use of your resources (capital, warehouse space, staff) you could order stock more frequently and work to reduce lead times. If your inventory turnover ratio increases, then you will know that your efforts have been successful and you now have more flexibility to reduce costs or grow sales.
With the inventory-to-sales ratio, you could negotiate better pricing with your suppliers or find a better value freight forwarding service. Then if you see it move from 0.2 for one year to 0.15 for the next, you will know that the amount of capital tied up in inventory has decreased.
That might not sound like much of a movement, but for a business with $1 million in annual sales, it means that the capital needed for inventory has gone down from $200,000 to $150,000. That $50,000 could be invested in new products to grow top-line sales.
So, each of the metrics can be useful on their own, but they are even more powerful when you use them together.
For example, you will improve your inventory turnover ratio much faster by concentrating on your best-selling products. The sell-through rate helps identify which products those are, so you can work with your suppliers to have smaller but more frequent orders.
Likewise, you might target your inventory-to-sales ratio by identifying slow-moving products and working to reduce your inventory of those to minimal levels, so you don’t have excess capital tied up in them. You could do that by increasing advertising, lowering prices, or reducing reorder quantities, among other things.
There are many other inventory management indicators that you can use, but the combination of the three metrics defined here can go a long way towards the success of your online retail business.
This post was by Fabricio Miranda, CEO and co-founder of Flieber, a supply-chain management and inventory optimization technology platform for multi-channel online retailers.
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