Knowing how to calculate average inventory in the right manner can significantly help reduce costs. When there is a lack of inventory, there are high chances you might lose potential customers and clients. On the other hand, if there is extra inventory, your business is most likely to face issues regarding working capital. So, inventory calculation is the key aspect of effective inventory management.
Effective inventory management ensures that enough inventory is maintained at a minimal cost at all times to meet production needs as well as consumers' demands.
In this article, we have discussed everything you need to know about how to calculate average inventory, its importance, formula, calculations, some examples, and their challenges in detail.
What Is Average Inventory?
Average inventory refers to the average value of the inventory in a business over a certain time frame. It is calculated by dividing the sum of, the beginning inventory balance and ending inventory balance, by 2. This provides an average amount that the company held in inventory over the period in question.
By ascertaining average inventory businesses can estimate the amount of inventory they have used in a certain time frame. So, every company must calculate the average inventory to estimate the required amount over various periods.
It also helps to track the level of stock as well as oversee inventory flow. It reveals the amount of stock required to fulfill the needs of the sales department.
In other words, average inventory is quite an important metric for manufacturers as their business is dependent largely on inventory. If you fall in any of these brackets by knowing the average inventory, you can manage your cash flow and know about revenues accurately. You would also be able to do profit projections carefully.
Importance of Average Inventory
Some businesses face regular issues regarding inventory management because of a lack of control over their inventory movements and fluctuating demand trends.
If this happens, on a certain day, you would be handling a huge influx of deliveries because of the high volume of orders, while on some other day, you might be unable to clear out the stocks before the next set of inventories delivered by suppliers.
This can become a huge problem for your business down the line. So, if you are a business owner, understanding the importance of average inventory calculation can save your business from crisis and make it a success.
Therefore, to overcome the issue of excess or less than required inventory, you must calculate the average inventory. This calculation will help you understand the trends and determine the optimum level of inventory required in your business.
Suppose on calculating average inventory, you notice that it is increasing slowly. It would be best to keep a close eye on the number of products ordered through your business. But, if you see that the average inventory level is below the required quantity, then you need to ensure that inventory is optimum else it may lead to a decrease in sales.
Inventory Turnover
Inventory turnover is an accounting metric that is helpful to assess the number of times the inventory of a business is sold and replaced in a period of time, usually in a financial year.
The formula for inventory turnover is:
Inventory Turnover = Cost of Goods Sold / Average Inventory
How to Calculate Average Inventory?
You can use the below-mentioned average inventory formula to complete all the calculations as per your requirement. However, if you want to calculate the average inventory for a longer period, you can divide the total amount by 12. Additionally, you can calculate on a smaller time frame by taking up the inventory at the beginning of a month and ending it, then dividing the whole by 2.
The average inventory formula is:
Average inventory = (current inventory + previous inventory)/ number of periods
Examples of Average Inventory Calculation
Here is an average inventory example so you can understand its concept easily. For example, the monetary value of inventory at the end of June, July, and August is Rs. 2,85,000, Rs. 3,13,000, and Rs. 1,12,000 respectively. Now to find out the average inventory of the quarter just add up the inventory of the previous three quarters and then divide it by the total number of months.
Total inventory level = (Rs. 2,85,000 + Rs. 3,13,000 + Rs. 1,12,000) = Rs. 7,10,000 Average inventory = Rs. 7,10,000/3 = Rs. 2,36,667.
In another example, let's say a shop has an inventory of 50 boxes on January 1st and 70 boxes on December 31st. The average inventory for the year would be (50 + 70) / 2 = 60.
Moving Average Inventory
Moving average inventory is a method of calculating the average inventory balance over a certain period of time, typically a few months. This approach is often used to smooth out fluctuations in inventory levels and provide a more accurate picture of a company's inventory management.
To calculate moving average inventory, you first need to determine the time period you want to analyze. For example, you may want to look at the average inventory over the past three months. Next, you add up the inventory balance at the end of each month for the time period and divide the total by the number of months. This will give you the moving average inventory for that time period.
How to Use Average Inventory Calculation
The average inventory calculation is a useful metric that can provide valuable insights into a company's inventory management practices. By understanding how to use this calculation, SME businesses can optimize their inventory levels, cut down costs, and maximize profitability.
To use average inventory calculation, first, determine the period of time you want to analyze. This could be a month, a quarter, or a year, depending on your business requirements. Once you have determined the period, calculate the beginning inventory balance and ending inventory balance for that period.
Next, add the beginning and ending inventory balances together and divide by 2 to get the average inventory for that period. This calculation provides a more accurate picture of the amount of inventory that the business held during that time, as it takes into account any fluctuations in inventory levels over the period.
Using the average inventory calculation can help businesses identify inefficiencies in their inventory management practices. A high average inventory may indicate that a company is overstocking or has excess inventory, which can tie up capital and increase storage costs. On the other hand, a low average inventory may indicate that a company is experiencing stock shortages or not keeping enough inventory to meet demand.
By tracking their average inventory over time, businesses can better understand their inventory trends and adjust their inventory management practices accordingly. For example, if a company consistently has a high average inventory, it may want to consider reducing the amount of inventory they hold or improving its forecasting methods to better anticipate demand. Conversely, if a company consistently has a low average inventory, it may want to consider increasing its inventory levels or adjusting its ordering processes to ensure they have enough inventory to meet demand.
Overall, the average inventory calculation is an essential tool for businesses looking to optimize their inventory management practices. By tracking this metric regularly and making adjustments as needed, businesses can reduce costs, improve efficiency, and increase profitability.
Challenges With Average Inventory
Just knowing how to calculate average inventory is not enough unless you are aware of the challenges involved.
Seasonal Fluctuation
In certain businesses, customers' demands change with the season, which needs to be properly analyzed. In seasonal businesses, the sales rate either goes up or down depending on the changing demand of the customers. In such a scenario, finding average inventory accurately becomes tricky.
Inventory Shrinkage
Many times, businesses face the problem of inventory theft. This has a direct impact on the accuracy of inventory calculation, as in case of stolen or lost inventory, both the beginning and ending inventory values will vary from actual thus resulting in an inaccurate average.
Market Trends
Every month a business has a specific sales target that needs to be achieved by the end of it. However, there could be a sudden drop in the total number of sales throughout the business due to unavoidable reasons like changes in market trends or inflation. In such scenarios, even average inventory calculation may not be able to save you from the losses incurred.
Time Period
Since inventory levels vary from time to time due to demand-supply fluctuation and other reasons, inventory calculation based on month, quarter, or year may not be accurate resulting in misrepresentation of the financial position of a company. So, for decision-making, it is suggested that you calculate inventory based on a shorter period while a longer period is suitable for financial reporting and auditing.
Boost Your Profitability With Accurate Average Inventory Calculation
Calculating average inventory can help you boost the profitability of your business as it prevents stockouts, improves cash flow, and reduces excess inventory. If you are looking for a perfect inventory management solution for your manufacturing unit, you can trust TranZact's smart and integrated inventory and production solutions. It offers real-time inventory valuation solutions along with features like stock reconciliation, and negative stock restriction to streamline your business. It provides you with all the data in an automated manner to calculate the average inventory.
FAQs on How to Calculate Average Inventory
1. How to calculate the average lead time in inventory?
To calculate the average lead time in inventory, you need to gather data on the lead time for each inventory item received during a specific time period. Add up the lead time for each item and divide by the number of items received to get the average lead time. This calculation helps businesses understand how long it takes to receive new inventory and plan accordingly to reduce the risk of stock shortages and improve customer satisfaction.
