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What is the Optimal Inventory Turnover Ratio?

Author Zilvinas Lapacinskas  Zilvinas
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– The average reading time for this post is 4 minutes –

“The higher – the better” might seem an obvious answer. A higher inventory turnover ratio (ITR) means that less inventory is required to support sales, therefore less warehouse space and capital are needed, which leads in turn to higher ROI and an increased bottom line.

But then – what exactly should your staff do in order to increase the ITR? Unfortunately, in most cases this question remains without an answer.

If you decide to merely decrease the inventory level, this may end up by ruining the service level and cutting sales, while at the same time creating an image of your company as an unreliable supplier.

The good news is that reduction of the inventory without cutting the service level is possible.  In order to decrease inventory safely, a distribution company must know the main factors that restrict the ITR from infinite increase.

Factor no.1. Replenishment Frequency

The inventory level for each single SKU fluctuates over time: it is at its minimum just before reception and at its maximum immediately after. Optimal inventory level is the quantity that covers all sales in the period between two stock arrivals. In the ideal case (when future sales are 100% known, supply is 100% reliable and no minimal supply batches are set) the ITR for an optimized inventory is 2 x the number of replenishments per year (see Illustration 1).

Inventory fluctuation in the ideal case when sales are 2 items per day and replenishment is 1 time per month.

Average inventory = 30 items

Annual sales =720 items

ITR = 720 / 30 = 24

1

The illustration above shows the lowest possible inventory level that provides the highest possible ITR for that replenishment frequency. A lower inventory level without increasing the replenishment frequency will certainly cause stock-outs. Only an increased replenishment frequency allows the inventory level to be moved down with safety.

Increasing replenishment frequency is a good idea, not only because of cutting inventories; it also enables a faster reaction when market conditions are changing, providing a higher service level in hardly predictable conditions.

Some companies say that additional costs for processing orders and receipts is the downside of an increase in replenishment frequency, but that is exactly where modern inventory management software systems can help. In real life, almost every company can increase the replenishment frequency for more than half of the SKU’s by at least twice, without any increase in operating costs.

Factor no.2. Reliability of Supply

Even the most reliable vendors fail from time to time in supplying goods; some orders do not arrive on time or in full quantities. If the inventory level is optimized according to replenishment frequency, stock-outs may occur. In cases where the reliability of supply is not very high, it would be good to add some quantities on top of the optimal inventory level in order to cover supply failures and provide a higher service level. Inventory can be reduced safely by choosing more reliable suppliers.

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Factor no.3. Supply Batches

Let’s assume that – as per our previous example – the vendor set a minimal order quantity of 360 items for our ideal item. Even with the possibility of replenishing every month, all annual quantities will now be supplied in two shipments per year, and the maximum possible ITR is 4 instead of 24, without any minimum order quantity constraint.

2

If the supply batch is much higher than the quantity sold during the shortest possible period between replenishments, we call it a “harmful” batch. Inventory level can be safely reduced by removing harmful batches.

Factor no.4. Sales Dynamics

In real life, sales dynamics are much more complex than in the example provided earlier. In many cases, sales are hardly predictable and vary between replenishment periods. For more details about sales dynamics, please refer to our post “Why Average Based Calculations Fail”. In daily routines, depending on sales dynamics, the lowest possible inventory would still be higher compared to the ideal case.

If a comparison is made between two items that have exactly the same replenishment frequency, annual sales and minimal batches, a higher inventory will be required for the item with bigger sales peaks and fluctuations. It is up to modern inventory management software such as Soft4Inventory to suggest the optimal inventory level for real-life sales dynamics and optimize it according to the replenishment frequency.

 

Our initial question was: what is the optimal inventory turnover ratio? We can see from the above considerations that the maximum ITR is restricted by factors such as replenishment frequency, reliability of supply, supply batches, and sales dynamics; ITR can be lower because of the poor quality of the inventory management software system. Modern, constantly improved inventory management systems such as Soft4Inventory allow the inventory levels to be kept close to the level set by the above-listed factors, probably providing the highest service level with the lowest possible inventory level. Optimal ITR is a very individual indicator for every single company, and the industry average value is not a measure to follow. Even the best ITR in your industry can be improved by making the right decisions based on reliable data.

 

SOFT4, as a provider of software solution for efficient inventory management, is constantly releasing blog articles about how to meet and cope with the trends, tendencies, and challenges, and give suggestions as to how to react to the changing environment in order to stay competitive.

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