How to improve inventory turnover and crush business goals
Each business is different, and each business has different requirements when it comes to handling stock. In this article, you’ll learn how to improve inventory turnover in your manufacturing business to reduce carrying costs and increase sales.
Inventory management is not only about the materials and goods you have at any time. It’s also important to consider the rate inventory arrives and leaves your shop floor. Your inventory turnover ratio is the amount you sell in relation to your average inventory.
It is a critical business performance metric, yet many manufacturers neglect this.
Knowing about your stock turns helps you to make decisions for your business.
It helps you answer questions like:
Am I keeping too much inventory at one time?
Am I selling enough?
Are my manufacturing costs too high?
Am I producing orders fast enough?
These questions go to the heart of inventory management and production flow. Therefore, you need to know how to calculate your inventory turnover. Your optimal turn rate depends on the size of your business and what you manufacture.
This article will help you learn how to improve inventory turnover rate, understand what is a good inventory turnover ratio, and apply it to your manufacturing business.
Katana ERP manufacturing inventory software
Katana is a platform that gives you real-time overviews of inventory and operations on your factory floors and within your warehouses
The Inventory turnover ratio is how often your company sells its inventory during a given period.
The inventory number is not your maximum inventory but your average inventory over this period. Average inventory is the average value of your inventory. This includes raw materials and direct labor costs, like when calculating the cost of goods sold.
Say you keep a constant stock of 10 items, and you sell 50 over a month.
You would have turned over your inventory five times. Knowing this ratio helps you make decisions for your business. Remember, sales revenue alone is not sufficient to gauge the success of a business.
You could have millions of dollars in sales revenues, but you’re in trouble if your expenses exceed this.
That’s why business guides stress the importance of always knowing your costs.
Why is inventory turnover ratio important?
It is a crucial measure of efficiency, as it calculates how much a business sells as a percentage of its total inventory. It tells you how much you sell as a ratio of what you keep in stock. This ratio tells you how many times you fully replenish your stock in a period such as a year.
For example, a company might have a huge average inventory but relatively low sales.
Can it justify having such large inventory levels if it turns over its inventory only one or two times a year? Well, the answer depends on several factors.
Large enterprises can afford to maintain a high average inventory because they sell a lot and/or have the funds to offset the required costs. It’s an inventory strategy used by manufacturers that mass-produce goods every day. This strategy is successful for large enterprises, so small businesses should seek to copy it.
Many people assume a scaling manufacturing business is just a scaled-down version of a large one — but this assumption could be detrimental to the business.
Scaling manufacturers usually produce more high-end goods. This means they use more expensive raw materials with possible bespoke features. The mass production model is lacking in these kinds of businesses, as they rely on higher margins for few products.
If a business keeps tons of stock in waiting, it could lose money without realizing it.
Improving your inventory turnover can let them know if their operations are running inefficiently.
Analyzing your inventory turnover allows you to scrutinize your business in a way you couldn’t do with the naked eye. Are you stocking more inventory than you could ever need? Calculating your inventory turnover ratio lets you know about this.
We will show you ways to have lower inventory levels when you understand this while keeping your sales high.
How to calculate inventory turnover ratio
You can calculate your inventory turnover for your company using the inventory turnover ratio formula.
This formula requires you to know two other financial metrics for your business:
To calculate average inventory, find the value of your entire inventory at the beginning and end of the financial period. Again, the right software can help you keep accurate records of this. Once you have done this, add your beginning and ending inventory together. Divide it by two to get your average inventory.
Now plug the numbers into the inventory turnover ratio formula:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
So, if your company has a monthly average inventory of $5,000 and a COGS of $7,000, you will have an inventory turnover ratio of 1.4. That means you have turned over your inventory just under one and a half times.
If you want to calculate the average time inventory is on hand, divide your inventory turnover ratio by the number of days. For example, calculating your inventory for October, it would be:
31 / 1.4 = 22.14
This means you turn over your inventory once every 22 days or so.
Let’s try another example of an inventory turnover ratio over one year. Say you are a high-end bicycle manufacturer.
You have a boutique store with one bike of each model you produce. This lets you save money and improve customer satisfaction by having bespoke manufacturing requests. Customers come in and buy your bikes to order.
Each bike costs $1,400 to produce, so you start with $9,800 inventory in stock. Because you practice lean manufacturing, you have limited raw materials and MRO in stock, valued at $1,200. That’s a total starting inventory of $11,000.
You have added two more models to your range by the end of the financial year. That plus raw materials come to $12,900.
Average inventory = (11,000 + 12,900) / 2 = $11,950
The cost of goods sold comes to $87,000.
Inventory Turnover Ratio = 87,000 / 11,950 = 7.3
So, the value of the average inventory was turned over 7.3 times.
To determine how many days it takes to turn over inventory once, divide the inventory turnover ratio by the number of days in a year, 365.25. This tells you this business took just over 50 days for one inventory turn.
What does the inventory turnover ratio tell us?
Is the turnover in the previous example good or bad?
Well, it depends on the goals and expectations of the business owner. That’s why this metric is so open to interpretation. It’s up to you to determine if your inventory turnover is adequate for your business, but we can give you some general tips.
Understanding your industry is crucial when figuring out your ideal inventory turnover ratio.
This could vary greatly depending on if you only manufacture bespoke goods, are in the food and beverage industry, or make craft goods with low margins.
How inventory turnover ratio works in manufacturing
Large manufacturers produce a lot and sell a lot.
They can afford a make-to-stock approach because they have a large budget and surefire demand. This is the key to not over-stretching yourself as a manufacturer. If they keep in-depth historical records, you can analyze them to make predictions about future demand planning.
For example, if a manufacturing company sold 50 to 100 items a month for the last year, it might be reasonable to assume that this will continue. You could tell your shop floor operations to make 50 units to stock before these orders come in. In fact, this is how many larger manufacturing businesses work.
Manufacturers of less mainstream, bespoke, or custom goods may find their demand rises and falls more often.
There is a danger for businesses keeping a lot of backup stock. If demand suddenly drops, you have extra safety stock taking up space. They have costs tied up in them, and unfinished goods have labor costs that amount to nothing.
Obsolete dead stock takes time and money to get off your shelves. This is not ideal for manufacturers. If you had no use for them, you could try selling them at a reduced price to entice orders. But again, this eats into your margins.
We hope you see the benefits of not keeping a large average inventory by now.
But what’s the alternative for manufacturing businesses?
Many businesses keep a very small number of demo items available on-premises. Most of their inventory is created when they receive an order for it. Large-scale manufacturers that mass-produce items tend to have high inventory turnover ratios because they have low margins.
Therefore, they must manufacture and produce many goods to become profitable.
There may be some exceptions, but most follow this general rule.
For example, automobile manufacturers pump out a seemingly constant stream of cars. This is because they know the demand will be there. As the model gets more high-end, then, of course, not as many are manufactured.
The manufacturer also takes more time on each unit.
Both a large-scale and scaling manufacturer can have a high turnover. They just need to find the happy medium that works for them.
Consider the bike industry once again. There is an almost endless number of bike sizes and styles available. The manufacturer producing bikes for Target and other large retailers has a constant production process.
They produce bicycles from Monday to Friday at a fast rate.
Contrast this with the bicycle maker. They produce bicycles with high-quality materials to high-end specifications. If they produced bikes at 100% capacity, they would run themselves into the ground. That’s why manufacturing orders puts far less stress on the scaling manufacturer.
This is a great example of how modern manufacturers compete with larger ones.
Scaling businesses bring something to the table they do not — higher quality goods made with passion and skill.
How to Improve Inventory Turnover
Once you understand how to improve inventory turnover for your business, the next step is putting it into practice.
Optimizing your inventory turnover rate will help you improve your inventory management, reduce manufacturing costs, and increase your sales. However, you’ll need to focus on and improve specific business areas after making your inventory turnover calculations to make this work. Here are some industry standards that other manufacturers use when attempting to increase inventory turnover rate in their business:
Increase demand for inventory
Cut down on costs
Improve time management
Optimize your supply chain
1. Increase demand for inventory
If your sales revenue seems lackluster, perhaps your sales are not high enough.
You could have the leanest manufacturing process globally, but you have problems if no one is buying your product.
The good news is that there are many ways to increase your sales. You could develop your company’s marketing efforts, for example. This doesn’t have to break the bank.
While you are generating interest in your products, find new sales channels to open. This could start with an e-commerce platform like Shopify. You first need to make sure it’s the right platform for your business needs and then understand the importance of Shopify inventory management.
Of course, you can also find other ways to sell in the real world, like getting spots at trade fairs or other events.
This, combined with online sales, is an excellent way of developing a customer base.
2. Effective pricing
Do you accurately value your raw materials, staff, and processing costs?
If you have a high turnover but low revenue, then perhaps you are not valuing your products highly enough. Do not undervalue your craftsmanship. Include all expenses and the profit margin in your final price.
Let the customer know they are buying an artisan product and show transparency in your production process.
Do not completely price out all potential customers. You have to find a happy medium. Increasing prices may lose some customers but improve overall profitability.
Just make sure your prices are a reasonable reflection of what you offer.
UK company Brompton charges more for one of their specialized bikes than a mass-produced one. They are targeting a specific audience base that is avid cyclists and willing to pay for the best.
3. Cut down on costs
Finding areas where you are spending more than necessary can bring down COGS and average inventory.
For example, each square meter you use to store inventory has a cost as a percentage of the rent you pay to house it. Inefficient manufacturing and shipping practices increase your COGS, which eats into your profits.
4. Improve time management
Does your shop floor utilize every minute of every day to its full extent? Or are there chunks of wasted time littered throughout a typical working day?
Take steps to optimize the time it takes your business to produce goods. Increasing the efficiency of your workshop means that materials and goods spend less time providing zero value for your business (in storage or transit). Instead, they are converted into revenue sooner, increasing your turnover.
5. Optimize your supply chain
Is there a weak spot in your supply chain? Do you wait weeks for a supply order to come into your shop floor?
The increased lead times mean your manufacturing output is lower. There’s no need to buy everything in bulk. For items with low storage requirements like MRO, this is okay.
But having raw materials and finished goods waiting around just raises your average inventory while doing nothing to increase sales.
The most obvious way to increase your inventory turnover is to order, not to keep adding to safety stock.
This means you keep a very limited amount of stock on hand at any one time. It ensures that materials and effort are not wasted as they ship everything they make straight away. A make-to-order workflow is the best way to increase your inventory turnover ratio.
Your inventory turnover will be much more agile.
Find Your Ideal Inventory Turnover Ratio
As discussed, your approach to your inventory turnover ratio depends on the size of your manufacturing business.
Scaling manufacturers should not strive to emulate their larger competitors. What is successful for a large business is not necessarily good for a small one. Conversely, many manufacturing practices do not scale up to large manufacturing.
The question “What is a good inventory turnover ratio?” is not so simple.
There is no one-size-fits-all approach to the whole manufacturing industry like anything else. It depends on what you manufacture and the size of your business. Manufacturers of mainstream, mass-produced products have an abundance of traceability software solutions that handle everything from finances to supply orders to inventory management.
These legacy systems can cost tens of thousands of dollars a year to run because they need to be powerful enough for a large-scale business.
Spreadsheets are okay for displaying data, but they can never match specialized software functionality. The problem is that most solutions treat scaling manufacturers as a scaled-down version of their larger counterparts. So, is there an alternative for micro and SMB manufacturers?
Introducing Katana ERP manufacturing software as a specifically tailored solution for the manufacturer searching for an answer on how to improve inventory turnover.
It is designed by experts in lean manufacturing to let you manage your specific workflow without the stress of running out of stock.
Improving your inventory turnover ratio with easy-to-use yet powerful metrics calculated automatically. All the facts and figures about your business are kept saved and up to date — making your inventory work for you.
Katana prevents you from manufacturing goods for them to sit around your warehouse doing nothing.
Keep your production flowing and increase inventory turnover. Try Katana for free. The first 14 days are free, so you can see firsthand how it can help you take your business to the next level.
Katana ERP manufacturing software
Katana comes with essential features for managing sales, manufacturing, and inventory — everything a manufacturer needs to calculate inventory turnover ratio.