Inventory turnover for Ecommerce sellers | How to calculate and optimize

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0:45

Okay, so before I get into calculating your inventory turnover and talking about why it matters, let's make sure we just have a basic understanding of what inventory turnover is.

So at a basic level, it is how quickly your inventory moves through your business. Another way to put it is it's how many times you sell the average amount of inventory you hold in a given period of time.

So let's do a quick example just to elaborate on that. Let's say that you sell shoes. You're looking at last year's sales and you sold 1,000 pairs of shoes, and throughout that year you averaged 250 pairs of shoes in stock. So to calculate, figure out your inventory turnover, you create a ratio of 1,000 to 250, which is a five to one ratio, which simply for your inventory turnover is just five. Now I'm just using units in this example, but as I dive into actually calculating your inventory, we're going to use real numbers.

1:49 The formula and the three steps

So the actual formula that you'll use to calculate your inventory turnover is your cost of goods sold divided by your average inventory. So it seems pretty easy on the outset, but the steps that we're going to go through is number one, you need to determine your COGS for the given time period that you're looking at. And this sounds very easy and simple, but it's amazing how many ecommerce companies struggle to actually get an accurate COGS and inventory. I'm going to put a link down below on some articles and blogs we have to help you with accurately calculating COGS and inventory.

Number two is determining your average inventory. And like I said, if you're recording this accurately it should be pretty easy, and I've got those links down below.

The third step is that you're going to divide your COGS by your average inventory to calculate your inventory turnover.

2:47 Finding your numbers, with a worked example

So first let's talk about determining your COGS. There's three places that you can look to get your COGS. You can look at your inventory management software. And then, since we are ecommerce accountants, we love financial statements, so obviously you should be able to find your COGS for a given time period on your income statement. Or finally, you can look at your balance sheet. You can take your beginning inventory plus your net inventory purchases on the year, and then you subtract away your ending inventory, and this should be roughly about the same as the COGS on your income statement.

So after you determine your COGS, you're going to want to determine your average inventory, and the way to find this is obviously on your balance sheet. You're going to look at your beginning inventory plus your ending inventory for this time period, divide that by two, and you'll have your average inventory.

3:42

So let's just look at an example. Over here on the right you'll see the numbers that we have. So you see our inventory at the beginning of the year [unclear], you see the ending inventory of that year, your [unclear] inventory, inventory purchases, and then your COGS for that year.

So we've got our formula over on the left. First we're going to determine our COGS. If you have accurate COGS numbers, you should look at the income statement, see that you have 800,000 in COGS. You can also go through your balance sheet. You can look at your beginning inventory minus your ending inventory and then add in your inventory purchases for the year.

Okay, and then looking at our average inventory, beginning inventory was 180 plus the 220 at the end of the year, divide that by two, and we've got 200,000. So putting those together for inventory turnover, 800,000 divided by 200,000 is going to give you an inventory ratio of 4.

4:47 Why inventory turnover matters

Okay, so now that you have a basic understanding of inventory turnover and how to calculate your inventory turnover, let's talk about why it's so important and how you can use this for your business.

First of all, inventory as an ecommerce seller is likely your biggest asset, so your inventory ratio is a good indicator of how well you're managing that asset and moving it through your business.

In general, you want your inventory turnover to be higher. And what it means when your inventory turnover is higher is that you're likely reducing a lot of costs that get tied up in warehousing your inventory, all the warehousing costs, the dead inventory. If you're holding inventory for a long time, you likely have more dead inventory. So at the end of the day, you're going to increase your profitability as an ecommerce seller by reducing your inventory turnover.

Another way to look at it is your inventory turnover, if it's higher, you have less cash tied up in that big asset as an ecommerce seller. So this gives you more cash to put into ads, marketing, new products, growing your business, and you just have more freedom and the ability to grow with your cash not tied up in your inventory.

6:04 What counts as a good number

Finally, a lot of people ask, what is a good inventory turnover number? It really depends on your industry. For a lot of ecommerce sellers that we work with in like online clothing and similar industries, four to six is a good ratio.

But you're going to want to calculate your inventory turnover and then benchmark that to your industry to see how well you're doing. If you have a higher turnover than your industry benchmark, that's awesome. It probably means you have a competitive advantage against other people in your industry. If it's lower, you're going to want to work on optimizing that turnover.

6:49 Five ways to optimize it

Okay, finally let's just talk about some ways that you can optimize your inventory turnover if you want to increase that number.

First of all, you can run some promotions. As you run promotions, and with all of these optimizing options, you want to look at your cost benefit analysis. For example, on the promotions you run, you want to consider your ROI on those promotions. Or if you're running some ads, always look at the ROI, make sure that it makes sense. At the end of the day, as you move your inventory through your business, you also want to make sure that you're doing it in the right way, in a profitable way.

7:22

So another way you can optimize inventory turnover is your purchasing frequency. The more often you purchase and the less amount that you purchase, that's going to give you a better inventory turnover. You're going to have less in your hands at any given time. And once again, you want to look at the cost benefit analysis. If you purchase more frequently with lower orders, how does that impact your purchasing power with suppliers and different things like that? But if you can get away with purchasing more often and less amount, then it's going to help your inventory turnover.

Number three is product pricing. Are you optimizing with your product pricing? Can you reduce price, move product through faster? But once again, look in and make sure that this isn't going to reduce your overall revenue numbers.

8:22

Number four is comparing SKUs. So this is important. As you look at inventory turnover, it can be beneficial to look at it by SKU. You may have some products that are selling faster, selling better, that are more profitable, and you can start to make comparisons and focus investment and efforts on the SKUs and products that make the most sense.

And then finally, you just want to look at inventory turnover trends over time. And as you do that, let's say you look at it month to month, you can compare it to different things that you have done in your business. If you change behavior or run some sort of marketing push in a certain month, how is that affecting your inventory turnover? And you can start to see and get some ideas on how to increase that by looking at the trends over time, and as it increases and decreases, looking at why it's maybe doing that.

9:20 Free exit PDF and next steps

If you'd like more key metrics to track and optimize as an ecommerce seller, download our PDF below about preparing for an ecommerce exit. It's never too early, it's never too late to prepare for an exit, and any stage that you're in, things in that PDF will help you to improve your business now and increase the value of your business later. At the bottom of the PDF you'll find those key metrics that you should be tracking and optimizing.

If you like this video, please like, subscribe to our channel for more ecommerce accounting and financial advice. If you're in a position where you need some help with your ecommerce accounting or some CFO-like services, please reach out to us. There will be links down below, and we look forward to learning about your business and helping you on your journey.