Managing inventory is crucial to any store’s success. If you don’t track your inventory levels, you won’t know when to replenish your inventory, your reorder quantity, or when you’re running low on stock. Inventory formulas are an essential tool for the critical task of overall inventory management, helping you better understand your bestselling products, gain insight into your sales cycle, and improve efficiency and profitability. Here’s what you need to know.
What are inventory formulas?
Inventory formulas typically are mathematical calculations that help a business owner efficiently manage inventory to control costs, reduce waste from spoilage or obsolescence, and maximize profitability.
These tools can show how much stock a business has on hand, how old it is, and how fast it will turn over. These calculations also help managers plan ahead to anticipate changes in demand. Ecommerce businesses and brick-and-mortar store owners typically review and update their inventory formulas monthly or quarterly to ensure that their inventory status is up to date. You can check and update your inventory valuation methods more frequently if you have large daily sales volume.
5 common inventory management formulas
- Inventory turnover ratio
- Gross margin return on investment (GMROI)
- Days sales of inventory (DSI)
- Inventory holding cost
- Inventory sell-through rate
Although there are several inventory formulas you can use for inventory management, here are the five most common ones:
1. Inventory turnover ratio
Inventory turnover ratio is the most common inventory metric used in retail. It measures the number of times your inventory is sold within a period of time, typically one year. The inventory turnover formula can help you establish whether new products are a hit or a miss, plus help you spot product trends like cyclicity or seasonality. Typically, you want to aim for a higher inventory turnover ratio, which indicates that you’re selling your inventory versus it sitting on the shelf.
The formula to calculate the inventory turnover ratio is as follows:
Inventory turnover ratio = Cost of goods sold (COGS) / Average inventory
COGS = Beginning inventory + Inventory purchases - Ending inventory
Average inventory = Beginning inventory value + End inventory / 2
For example, if you have $10,000 in COGS, with an average inventory of $4,500, your inventory turnover ratio calculation would be $10,000 / $4,500 = 2.22, which means you turnover your entire inventory just over two times a year.
2. Gross margin return on investment (GMROI)
Gross margin return on investment, or GMROI, is how much money your business generates for every dollar spent on inventory, and a higher figure is better. GMROI gives you insight into which products are most profitable and which aren’t. Store owners can use these insights to plan future product releases and determine what products are worth investing in.
The formula to calculate GMROI is as follows:
GMROI = Gross margin / Average inventory cost x 100
For example, if your gross margin is $20,000 and your average inventory cost is $32,000, the calculation would be $20,000 / $32,000 = 0.625. Multiply this result by 100 to convert it to a percentage, or 62.5%, which is your GMROI. A higher percentage indicates greater profitability, giving a store owner critical information when deciding to invest in inventory.
3. Days sales of inventory (DSI)
Days sales of inventory, or DSI, gives you the number of days your store takes to sell its inventory and how many days of merchandise you have left. DSI can help store owners avoid low stock and stockouts by monitoring inventory numbers, proactively reordering products, and spending more efficiently.
The formula to calculate DSI is as follows:
DSI = (Inventory / COGS) x 365 days
For example, if you have 12,000 units in your inventory with $37,000 in COGS, the calculation would look like this: 12,000 / 37,000 = 0.32. Multiplying this figure by 365 indicates that it will take you about 118 days to sell your inventory. Another way to look at it is that you have 118 days of merchandise left in inventory before you stock out.
4. Inventory holding cost
Inventory holding cost tells you how much you’re spending on warehousing, insurance, and other costs associated with storing your merchandise. It helps business owners understand how long they can keep stock before it becomes unprofitable. It also helps determine the minimum stock levels you need to maintain optimal inventory levels. Ideally, inventory holding costs shouldn’t exceed 20% to 30% of your inventory’s annual value, and a lower figure indicates more effective inventory management.
The formula is as follows:
Inventory holding cost = Warehousing + Labor + Opportunity cost + Depreciation / Inventory value x 100
Imagine you have the following expenses: $2,000 for warehousing, $5,000 in labor, $2,250 in opportunity cost (reflecting other ways you could have spent the money), and $3,500 in depreciation for a total of $12,750. Meanwhile, your inventory value is $36,000. Then do the following calculation: $12,750 / $36,000 = 0.354. Multiplying this figure by 100 shows that your inventory holding cost is 35.4%. This means that it costs you a little more than $35 for every $100 of your inventory’s annual value to hold it.
5. Inventory sell-through rate
The inventory sell-through rate is how much inventory you’ve sold in a particular time period (typically 30 days) compared to how much stock you receive from your supplier in the matching period. Inventory sell-through rate can help you establish a baseline for how quickly you sell a product and product-market fit. The rate can also help you quickly identify the top and bottom performers at the individual product level.
The formula to calculate the inventory sell-through rate is as follows:
Inventory sell-through rate = Total units sold / Number of units received x 100
For example, if you sell 50,000 units in a month and receive 75,000 units, you would do the following calculation: 50,000 / 75,000 = 0.66, which when multiplied by 100 to convert the result to a percentage indicates that your inventory sell-through rate is 66.6%. In other words, for that period, you sell through almost 67 of every 100 units received.
Benefits of inventory management
A proper inventory management system is crucial for boosting sales, delivering a better customer experience, and keeping costs in check. Inventory management helps retailers ensure they have enough supply to meet customer demand and deliver products on time.
Additionally, inventory management gives retailers insight into when they will receive items from their suppliers, indicates reorder points, and tracks product sales. This helps ensure that you have the right products and amounts so you neither have excess inventory (also known as dead stock) that incurs storage and other costs, nor a shortage.
Common causes of mismanaged retail inventory
Ineffective inventory management can lead to low stock or stockouts (running out of inventory), costing your company time and money, and potentially causing reputational harm. Here are a few common causes of mismanaged retail inventory:
- Inaccurate forecasts. Inaccurate inventory forecasts can lead to overbuying, underbuying, buying the wrong products, or misallocating inventory. This can result in additional storage costs, dead stock, unplanned markdowns, stockouts, and unnecessary capital investment.
- Data entry errors. If you’re recording your inventory by hand or manually on a spreadsheet, your data is subject to human error, which gives you inaccurate inventory levels. Manual data entry also is time-consuming, using human capital that could be put to use elsewhere in the business.
- Supply chain bottlenecks. Failing to understand or be aware of constraints in supply chains can not only lead to shortages, but make it hard to arrange alternative logistics channels and raw material sourcing.
- Incomplete data. If you’re missing key inventory metrics or data, it can affect your inventory levels and demand forecasting. You’ll also be missing real-time data on supply chain operations.
Rather than calculating your inventory metrics manually, Shopify POS can help you break free from spreadsheets and time-intensive inventory management processes. View inventory reports to track how much inventory you sell and have left, how much it’s worth, inventory costs, and much more. Shopify POS merchants can also get more in-depth inventory reporting and analytics with the Stocky app, which creates and tracks purchase orders, identifies the most profitable products and monitors stock to optimize inventory management decisions.
Inventory formulas FAQ
What does a high or low inventory turnover ratio indicate?
If your inventory turnover ratio is too low, you’re not selling your products quickly enough and must revisit your product selection, marketing, pricing, and sales strategies. A high inventory turnover ratio means your store moves through its inventory quickly and may need to order more stock upfront so your store isn’t at risk of stockout.
What is the stock-to-sales ratio, and how is it useful?
Stock-to-sales ratio is the relationship between your inventory value and your total sales. It assesses the capital allocated to inventory compared to the company’s historical sales data in a given period. You can calculate the stock-to-sales ratio by dividing your inventory cost by sales.
What is safety stock, and why is it important?
Safety stock is the amount of reserve inventory held in storage. This extra inventory allows stores to deal with unforeseen events such as spikes in demand, unexpected changes in product turnover, and supplier delays.
