Inventory Turnover in 3 minutes

Inventory turnover is a popular inventory management concept that is used to determine the overall efficiency of an entire supply chain. The ratio reflects the number of times inventory is replaced during a given period of time, and can give a useful indication of both trends and how well a company controls its merchandise. Numerically, it is calculated as the ratio between the cost of goods sold, divided by the cost price of the average stock level over the same time period.

Typically, retail companies want this ratio to be as high as possible, as it indicates that they don’t overspend by buying too much inventory, or waste resources on items that don’t sell, and that the inventory they do buy can be sold effectively. This result can provide valuable insights from a supply chain management perspective, as SKUs associated with low inventory turnover ratios indicate that a company is holding excessive, or even dead inventory, and as such can help in identifying items to be written off.

As such, inventory turnover gives companies a clear aim; to rotate inventory as many times as possible to maximise profit. This introduces a multiplier effect that highlights a company’s capacity to generate profit on capital. However, despite the popular belief that inventory turnover ratios are a good proxy of a company’s supply chain performance, these indicators do have their limitations.

In reality, businesses want to look at the margin they are making with a product, as this is a key driver that shows which items you should be focusing on turning over as many times as possible. The concept also ignores supplier constraints, like batch sizes, MOQs and lead times that in practice are usually the driving force behind the observed inventory turnover ratios. For example, with overseas suppliers it makes sense to hold higher stock levels, as the stock needed to cover the whole lead demand is higher. As such, inventory turnover only takes an average viewpoint and does not reflect the fluctuations of inventory and activity during a year, for example with seasonal sales peaks.

To conclude, taking a “lower turns” perspective is narrow, and whilst it provides a good overview, it does not capture what is usually perceived as a high-performance supply chain. Therefore, turns should be seen as a balance between the cost of inventory and the cost of stock-outs. Whilst it may provide valuable high level insights about the supply chain, refining these measurements so that they are done the “right” way requires a lot of effort, which can only be achieved through bespoke implementations.

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