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Business Unplugged™
This blog features Carol Roth's tough love on business and entrepreneurship, as well as insights from Carol's community of contributors.

Goldilocks and the Inventory Turnover Ratio

Written By: Nicole Fende | No Comments

How would you describe your porridge inventory levels?

Are you using words like sufficient, plenty or low?

When you are describing your favorite quarterback’s performance, do you say sufficient or do you say his completion ratio is 71.5%?  Granted, you need to be an Aaron Rodgers fan to say 71.5% but you get the idea (shhh, don’t tell Carol that I’m a Packers fan).

When you are serious about how someone or something performs, you track their key statistics.  Doesn’t your business deserve as much attention as your favorite sports team?

Why Goldilocks is a Great Role Model (for Inventory Turnover).

Analyzing your inventory turnover is as easy as making instant oatmeal.

Calculating the Ratio

Inventory Turnover Ratio = Sales divided by Current Inventory
When calculating the ratio, it is crucial that the sales and inventory are for the same period of time.  For example, if your company had sales of $100,000 in the last month and your current inventory (at cost) is $10,000, then your Inventory Turnover Ratio (ITR) would be

$100,000 / $10,000 = 10

So, what does it tell us? In this example, the business turned over its inventory 10 times during the month.  Another way to think of it is that for every dollar spent on inventory, the company was able to produce $10 in sales in one month.

Goldilocks Weighs In

Of course, no number is useful without context.  If I simply say 71.5%, you can’t be sure if I mean Aaron Rodgers’ completion ratio, the odds of the Packers winning a game played at Lambeau Field or even the alcohol content in a Cheesehead’s favorite drink (hey, it gets cold there!).

The Number is Too High

A number that is too high means that you are not carrying sufficient stock.  You are running the risk of not having the desired inventory on hand, which means you could be losing sales.

The Number is Too Low

You’ve got too much money tied up in stock.  Your return is low and you run the risk of your merchandise becoming obsolete, outdated or just plain old.

Your inventory is like any other investment and you should be expecting a strong return.  Would you buy CDs right now with a 2% interest rate?  No.  Then why do the same thing with your inventory?

The Number is Just Right

The goal, like Goldilocks, is to be just right. Since this varies by industry, check out the competition with www.BizStats.com (free) or look in industry trade magazines to get a rough idea to start.  Then, track your numbers and inventory issues each month.  When your ratio was 10, were you constantly running out of your best sellers?  Or were your inventory levels a textbook example of just-in-time stocking?

Porridge with Brown Sugar, Blueberries, Raspberries…

There are alternatives to the simplest formula stated above.  Just think about all of the different flavors of oatmeal you can buy now.  For those who use GAAP (Generally Accepted Accounting Principles) the default equation is:

GAAP Inventory Turnover = Cost of Goods Sold divided by Average Inventory in the Period

Goldilocks only had three options, yours are limitless.  There are plenty of ways to slice and dice this statistic.  Select the one that is most appropriate for your business and then use it consistently month to month.

Are you the Aaron Rodgers of inventory turnover?  What tips can you share that keep you on target with stocking levels?  Or are you still struggling like Goldilocks to find a level that maximizes your dollar?  What seems to be your biggest barrier to getting it just right?

Article written by
Nicole Fende is The Numbers Whisperer™. Her mission is to free small business owners from the fear of finance and humor is her weapon of choice. In her new book, How to be a Finance Rock Star, Nicole draws on her worldwide experience in companies large and small to help businesspeople overcome their fear while making finance fun. Want to give your finance fears the boot? Sign up for Nicole’s free eCourse.