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.
View Top Multichannel Management ToolsWhat 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.
