Achieving the perfect inventory balance shows a company's cost management, sales, and business relationships strengths. Calculating the average inventory level is a valuable accounting tool for monitoring changes in stock over time.
Maintaining average inventory is important for cost control and keeping customers happy. Excess inventory ties up funds and can become a risk, mostly for items with limited shelf life or popularity. In contrast, too little inventory leads to missed sales and empty shelves.
In this article, we will discuss all the ins and outs of the average inventory and why it is important for the business.
Define Average Inventory
Average inventory is a way to calculate how much inventory a company holds during a specific time frame. Month-end inventory levels can vary greatly due to large shipments, buying surges, or peak seasons that quickly use up stock.
Calculating average inventory smooths out these sudden ups and downs, giving a more accurate picture of inventory status.
Average Inventory: Key Takeaways
- Average inventory represents the average value of your inventory across multiple accounting periods.
- It's the main value of inventory during a specific timeframe.
- Average inventory is handy for valuable comparisons with other data. For instance, you can compare it to total sales during the same period to track inventory losses caused by damage, shrinkage, and theft.
An Overview of Average Inventory
The average inventory shows the average inventory value of the items over multiple accounting periods. For a yearly average, you would add up the inventory counts at the end of each month and then divide that by the number of months.
NOTE: When calculating the average inventory for a fiscal year, include the starting month; you divide by 13 months instead of 12. This approach is used for other time frames, too. Compare the revenue of your previous fiscal year with the average inventory during that time. It gives you an idea of how much stock you need on average each month to support those sales. You can do the same analysis for a quarter, a year-to-date, or a month.
Average Inventory: Its Importance
Inventory levels are always changing. Sometimes you receive a big shipment at the end of a month; other times, you're stocking up for sale, or your business is tied to seasons, like selling ACs in summer or holiday items in winter.
Just looking at the overall stock won't show the true inventory status. You need a clear number when you're talking to suppliers for orders or deciding how much to order. That's where average inventory helps; it helps decide how much inventory you need to support sales and make maximum profits.
Average inventory is also important for understanding how quickly you turn inventory into sales. It is calculated using the days' sales of inventory (DSI) and inventory turnover ratio.
Define Inventory Turnover Ratio
The inventory turnover ratio helps you see how much time passes between buying inventory and selling the final product to customers. It also signals if you're holding onto excess stock.
- A higher ratio means you're restocking inventory and moving products.
- However, it could suggest lost sales if you're not keeping enough inventory to meet demand.
Compare your ratio to similar companies' ratios to measure your performance.
To calculate the inventory turnover ratio, first find the average inventory and the cost of goods sold (COGS), which covers making your products, including materials and labor. It's usually in your income statement. Then, use this formula:
Inventory turnover ratio = Cost of goods sold / average inventory
The days' sales of inventory (DSI) measures how many days it takes to sell your inventory. You'll need the average inventory again.
DSI = average inventory / COGS (Cost of goods sold) X 365 days.
How to Calculate Average Inventory?
This formula calculates the average inventory for two or more accounting periods. You can even adapt it for longer stretches, such as adding up monthly inventory over a year and dividing by 12, or for shorter periods, like a single month, by averaging the beginning and end-of-month inventories.
The average inventory formula is:
Average Inventory = (current inventory + previous inventory) / total periods.
Examples of Average Inventories
Consider this example.
Let's say you have inventory at the end of October, November, and December of Rs. 280,000, Rs. 315,000, and Rs. 111,000, respectively.
To find the average inventory for the fourth quarter, add these three values together and divide by the number of months. You can perform this calculation by using the average inventory cost formula:
For the last quarter of the year:
- October's inventory: Rs. 280,000
- November's inventory: Rs. 315,000
- December's inventory: Rs. 111,000
Total: Rs. 710,000 Average inventory = Rs. 706,000 / 3 = Rs. 235,333
Now, if you want to calculate the average inventory in terms of units instead of money, the process is the same.
For example, let's consider a hotel; if they had 20,000 boxes of flour at the end of the previous month and now have 30,000 boxes, the average inventory for the two months is calculated by adding these two numbers and then dividing by 2:
For the hotel's inventory:
- October: 20,000 boxes of flour
- November: 30,000 boxes of flour
Total: 70,000 pallets of flour Average inventory = 70,000 / 2 = 35,000 boxes of flour.
What Is the Moving Average Inventory?
Modern technology like inventory management software instantly updates the inventory status as sales happen and items are added or restocked. A useful tool for companies using the perpetual inventory method is the moving average inventory.
This technique lets them compare inventory averages over different periods. The moving average adjusts prices to the current market norms, making period-to-period comparisons more accurate.
Problems, Challenges, and Drawbacks With Average Inventory
Although average inventory proves valuable for inventory management, it has its limitations:
- When a company has peak sales during certain seasons, it affects stock levels and the average inventory calculations.
- Month-end inventories might be influenced by the need to meet sales quotas. It could cause an unusual drop in end-of-month inventory, appearing much lower than regular inventory levels.
- Using approximate inventory figures isn't as accurate as real physical counts. Estimations can lead to mistakes in understanding actual inventory status.
3 Ways to Use Average Inventory Results
Average inventory results can be used across various accounting and planning tasks:
- It is used for calculating the average turnover ratio. The average turnover ratio measures the time taken to sell inventory after purchasing it. To calculate this, divide the yearly cost of goods sold by the total ending inventory.
- It is used for calculating the average inventory for a period. Average inventory is calculated over two or more periods, such as months or quarters. It evens out spikes and drops in inventory, offering a steady metric.
- It can also be used for sales support calculations. Comparing average inventory to revenues in income statements helps determine the inventory needed to sustain specific sales levels.
Track Average Inventory Easily With TranZact
Using TranZact's inventory management software helps make keeping tabs on your average inventory easier. With its user-friendly features, you can effortlessly monitor your inventory's average levels and make informed decisions for your business.
FAQs on Average Inventory
1. What is average inventory?
Average inventory is the average amount of stock a business holds over a specific time, helping to manage inventory levels properly.
2. How do I calculate average inventory?
You can calculate the average inventory by adding the ending inventory for each period and dividing by the number of periods. For example, if you have three months, add the inventories and divide by three.
3. Why is average inventory important?
Average inventory is important because it gives a stable view of stock levels, aiding in smart decision-making about buying and selling products.
4. Can average inventory be used to compare periods?
Yes, you can compare average inventory across different time frames, like months or quarters, to see trends and patterns.
For example, a clothing store wants to examine its inventory trends over the past year. They calculate the average inventory for each quarter:
(January to March): Average inventory = (Beginning Inventory + Ending Inventory) / 2 = (1000 + 1100) / 2 = 1050 units (April to June): Average inventory = (Beginning Inventory + Ending Inventory) / 2 = (1100 + 900) / 2 = 1000 units. So on and so forth.
5. How does average inventory help with sales analysis?
By comparing average inventory to sales revenue, you can figure out how much stock is needed to support specific sales levels, providing insights into sales performance.
6. What is the weighted average inventory method?
The weighted average inventory method calculates the average cost of all units in inventory, including both the cost of older and newer units.
7. What is the average inventory formula for the supply chain?
The average inventory formula for the supply chain is calculated as follows: Average Inventory = (Beginning Inventory + Ending Inventory) / 2.
