Blog Credit: Abby Jenkins, January 13, 2021 (Average Inventory Defined: Formula, Use, & Challenges | NetSuite)
Inventory management is key to managing costs and maintaining customer satisfaction. Too much inventory on hand means capital is tied up unnecessarily and may even be at risk. For example, some perishable, trendy or seasonal items may not last for long. Too little inventory on hand can lead to missed sales opportunities and empty store shelves. Just the right amount of inventory propels a company forward and mirrors its strengths in managing costs, sales and business relationships.
Calculating average inventory is a useful accounting measure to track changes and activities over time. This is often a better lens to view a company’s inventory standing than a single point in time or accounting period.
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What Is Average Inventory?
Average inventory is an estimation of the amount or value of inventory a company has over a specific amount of time. Inventory balances at the end of each month can fluctuate widely depending on when large shipments are received and when there’s a buying surge or peak season that may markedly deplete the inventory. An average inventory calculation evens out such sudden spikes in either direction and delivers a more stable indicator of inventory readiness.
What Is Inventory? Inventory can be raw materials or finished products, and the term refers to the number of goods on hand ready for sale or the amount of raw material on hand to produce salable goods.
- Average inventory is the average amount or value of your inventory over two or more accounting periods.
- It is the mean value of inventory over a given amount of time. That value may or may not equal the median value derived from the same data.
- Average inventory can be used for meaningful comparisons to other data points. For example, in tracking inventory losses due to shrinkage, damage and theft by comparing average inventory to overall sales volume in the same period.
Average Inventory Explained
Average inventory is a calculation of inventory items averaged over two or more accounting periods. To calculate the average inventory over a year, add the inventory counts at the end of each month and then divide that by the number of months. Remember to also include the base month in fiscal year average inventory calculations which also means you would divide that sum by 13 months rather than 12. Average inventory figures for other stretches of time are similarly calculated.
Here’s one way to use average inventory for a comparison. Take the revenue from your last fiscal year and compare it to your average inventory from the same time. This will show you how much inventory each month on average you needed to supply and support that amount of sales. You could perform the same exercise for any given period—year-to-date, a quarter or even a month.
Importance of Average Inventory
Your inventory will fluctuate. You might get a massive delivery at the end of the month. Or you might be stocking up for a specific sale. Or maybe your business is seasonal—like ice cream in the summer or holiday decorations in winter. Looking at a single point in time won’t necessarily give you an accurate picture of your inventory.
When negotiating with suppliers and making strategic decisions about how much stock to order, you need to have a good grasp on the big picture. How much inventory will you need to support the sales to fund the bottom line? The average inventory can help by giving you the overview for a given period.
The average inventory is also a key component of understanding how quickly you’re able to turn inventory into sales. This is done with the inventory turnover ratio and the days sales of inventory (DSI).
What Is Inventory Turnover Ratio?
The inventory turnover ratio is a way to look at how much time passes between when you buy inventory and when the final product is sold to your customers. It also shows if you’re holding onto too much stock. A higher turnover ratio means you’re replacing your inventory and moving product. But it can also be an indicator of lost sales if you’re not holding onto enough inventory to meet demand. Benchmark your business against peer company ratios to see how you’re performing.
To calculate the inventory turnover ratio, start by finding the average inventory and the cost of goods sold (COGS), which is a measure of how much it takes to produce your goods including materials and labor. It is usually listed on your income statement. Then follow this formula:
Inventory turnover ratio = Cost of goods sold / average inventory
The DSI is a measure of how many days it takes for your inventory to be sold. You’ll need the average inventory again for this formula.
DSI = average inventory / COGS X 365
Lower DSI is usually desirable, but like inventory turnover ratio this will vary by industry. Benchmark your DSI against peer companies to get idea of performance.
Average Inventory Formula and Calculations
Determine average inventory for two or more accounting time periods using the following formula. Keep in mind, you could extend this formula to cover extended periods of time, like adding up the inventory at the end of each month in a year and dividing by 12. You can also look at smaller timeframes, like looking at a single month by taking the inventory at the beginning of a month and end of a month and dividing by 2.
Average Inventory = (current inventory + previous inventory) / number of periods
Average Inventory Examples
For example, if the monetary value of inventory at the close of October, November and December is $285,000, $313,00 and $112,000, the average inventory for the fourth quarter would be the sum of all three divided by the number of months.
|October ending inventory: $285,000|
|November ending inventory: $313,000|
|December ending inventory: $112,000|
|Average inventory = $710,000 / 3 = $236,667|
Calculating average inventory in terms of number of units instead of monetary value is done the same way. If a bakery’s previous month’s inventory balance is 30,000 pallets of flour and the current inventory balance is 45,000 pallets, then the average inventory for the two months is 30,000 plus 45,000 divided by 2—or 37,500 pallets of flour.
|October: 30,000 pallets of flour|
|November: 45,000 pallets of flour|
|Total: 75,000 pallets of flour|
|Average inventory = 75,000/2 = 37,500 pallets of flour|
Moving Average Inventory
Companies using the perpetual inventory method in accounting have a continuous real-time record of inventory. Computerized point-of-sale systems and inventory management software immediately reflect changes in inventory by tracking sales and inventory depletion or restocking.
Companies that use the perpetual inventory method can use a moving average inventory to compare inventory averages across multiple time periods. Moving average inventory converts pricing to the current market standard to enable a more accurate comparison of the periods.
3 Problems, Drawbacks and Challenges with Average Inventory
While average inventory is useful in inventory management, it does have a few drawbacks:
- Inaccuracies due to seasonal cycles. If a company makes a large portion of its sales in a specific season it skews inventory balances and the average inventory. Typically, inventory balances are abnormally high just prior to a seasonal sales spike and abnormally low afterwards.
- The quota factor. Month end inventory balances may reflect a push to meet sales quotas. This can lead to an artificial drop in month-end inventory levels that are far below the daily inventory norms.
- Estimated balances lead to errors. Using estimated inventory balances isn’t as accurate as using physical counts of inventory.
3 Ways to Use Average Inventory Results
Average inventory results are useful for a variety of meaningful accounting and planning tasks. Here are the most common:
- Calculating average turnover ratio. The average turnover ratio is a measure of the amount of time it took to sell inventory after you purchased it. To calculate it, divide the total ending inventory into the annual cost of goods sold. For example: your ending inventory is $30,000 and your cost of goods sold is $45,000. Divide $45,000 by $30,000 which equals 1.5. This means your inventory has turned (been sold) one- and one-half times during the year.
- Calculating average inventory for the period. Average inventory by definition must be calculated over at least two periods. That means you can average two or more months, quarters or other time periods. Average inventory will lessen the impact of spikes and dips in inventory to render a more stable measure to base decisions upon or to compare to other metrics.
- Sales support calculations. Average inventory is useful for comparison to revenues derived from income statements to determine how much inventory is needed to support a given sales level. These comparisons can be done over two or more accounting periods, and even as year-to-date comparisons. Matching sales against average inventory figures reveals the average number of units you sold to generate that amount of sales revenue.
For example, if the average for your quarterly sales is $60,000 and the average inventory is 10,000 units, then you sold an average of 10,000 units each month in the quarter to generate $60,000 in sales for the period.
Average inventory is an important element in sales planning to ensure enough raw materials or finished products are available to meet orders, but not so much as to drive up warehousing and other related costs.
But both inventory measures and inventory planning must be done regularly to take into account changing business, economic and environmental changes as was recently demonstrated in the latest pandemic. Average inventory is just one tool in the toolbox of inventory management.