For modern online retailers, efficient management of inventory levels is becoming ever more critical. Two of the most widely used metrics to measure inventory efficiency are inventory turnover and inventory to sales ratio, or I/S ratio. In this post, we’ll explain I/S ratio.
The I/S ratio represents the relationship between your inventory value and your total sales. Its objective is to monitor the capital allocated to inventory, as compared to the company’s sales volume in a given period. The lower the I/S ratio, the more efficient the company is in allocating capital to its inventory.
From a mathematical perspective, when a company has an I/S ratio of 1.0, it means that during the period analyzed, they had the same capital invested in inventory as their total sales. However, there’s more you need to understand to get the full picture.
The I/S ratio compares inventory value, which is based on the cost of your goods, with sales, which is based on the sales price of the goods. You’re not comparing bananas with bananas, as you do with the Inventory Turnover Ratio. So you may wonder why we’re comparing bananas with pineapples. Why not just use the Inventory Turnover Ratio?
The Inventory Turnover Ratio is very useful to understand how many times you churn your inventory during a given period, while the I/S ratio is used to understand how efficient you are in allocating capital to your inventory. These are two important ratios with two very different objectives.
Calculating I/S ratio
To explain how to calculate and interpret the I/S ratio, we’ll use an example. Let’s look at two companies; Allen’s Arrows and Bob’s Books.
- Allen’s Arrows sells arrows that costs $5 and are sold for $20. During the last 30 days, Allen sold 5,000 units, generating $100,000 in sales. In the same 30 days, they carried an average of 5,000 units in inventory, at a total cost of $25,000.
- Bob’s Books sells books, with the same cost of $5 and sales price of $20. During the last 30 days, Bob sold the same 5,000 units, generating the same $100,000 in sales. But unlike Allen’s Arrows, during this period it carried an average of 10,000 units in inventory, at a total cost of $50,000.
The I/S ratio formula is: Average Inventory Value / Net Sales
Let’s apply this formula to our two examples:
- For Allen’s Arrows, the I/S ratio is 25,000 divided by 100,000, which results in 0.25
- For Bob’s Books, the I/S ratio is 50,000 divided by 100,000, which results in 0.50
This means that for every 1 dollar sold, Allen’s Arrows had 25 cents invested in inventory. On the other hand, Bob’s Books had invested 50 cents for every 1 dollar sold—two times more than Allen’s Arrows. Remember, both companies sell a product with the same cost and the same sales price, and the only variation here was in the inventory level.
Now let’s add a third company, Carol’s Cupcakes to the example.
- Carol’s Cupcakes sells the cupcakes, with the same cost of $5 and sales price of $20. During the last 30 days, Carol sold the same 5,000 units, generating the same $100,000 in sales. The only difference between Carol’s Cupcakes and the previous companies is that Carol carried an average of 2,500 units in inventory, at a total cost of $12,500.
We’ll apply the same formula:
- For Carol’s Cupcakes, the I/S ratio is 12,500 divided by 100,000, which results in 0.125
For every $1 sold, Carol’s Cupcakes needed only 12.5 cents invested in inventory, which is half of what Allen’s Arrows needed and ¼ of what Bob’s Books needed. That might seem great, but here’s the trick: to carry an average of 2,500 units in stock during the month, it means that it started with 5,000 units and ended with 0. In other words, Carol’s Cupcakes is out of stock.
What is the right I/S ratio?
Carol’s Cupcakes is a great example of why you shouldn’t aim for the lowest I/S ratio, but the healthiest one. When it comes to inventory, you should always try to keep the right balance. If you’re overstocked, you are investing more capital than you need to, but if you try to keep that investment as low as possible, you risk being out of stock.
How do you achieve the right I/S ratio?
Achieving the right balance is challenging, particularly in a fast-paced, ever changing global marketplace, where sales and shipping times are constantly fluctuating. There are multiple factors that contribute to sales and replenishment of inventory, including supply chain operations, historic and current sales data, and marketing campaigns, to name few. In order to accurately identify how much stock to carry to maintain a healthy I/S ratio and avoid both stockout and overstock, you must take all these factors into account. All this data needs to be aggregated regularly (ideally in real-time), while accounting for seasonality, stockouts, and outliers (such COVID-19). With this information, you can accurately forecast sales and inventory.
Flieber is an inventory forecasting platform that does the heavy lifting for you – it listens to your supply chain operations, sales, and marketing data, and leverages artificial intelligence (AI) to provide real-time dashboards and recommendations for the most important questions in online retail to optimize your I/S ratio:
- What products to order?
- How much to order?
- When to order?
- Where to deliver?
Schedule a demo to learn more about Flieber, and learn how it can integrate with your supply chain, sales, and marketing operations to start identifying the right I/S ratio for your business.