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.
Understanding Average Inventory
Inventory is the value of all the goods ready for sale or all of the raw materials to create those goods that are stored by a company. Successful inventory management is a key focal point for companies as it allows them to better manage their overall business in terms of sales, costs, and relationships with their suppliers.
Since two points do not always accurately represent changes in inventory over different time periods, average inventory is frequently calculated by using the number of points needed to more accurately reflect activities across a certain amount of time.
For instance, if a business was attempting to calculate the average inventory over the course of a fiscal year, it may be more accurate to use the inventory count from the end of each month, including the base month. The values associated with each point are added together and divided by the number of points, in this case, 13, to determine the average inventory.
The average inventory figures can be used as a point of comparison when looking at overall sales volume, allowing a business to track inventory losses that may have occurred due to theft or shrinkage, or due to damaged goods caused by mishandling. It also accounts for any perishable inventory that has expired.
The formula for average inventory can be expressed as follows:
Average Inventory = (Current Inventory + Previous Inventory) / Number of Periods
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).
How to use average inventory calculations
Here are a few ways you can use the results of your average inventory calculations:
1. Calculating the inventory turnover ratio
The inventory turnover ratio is an effective measure of how well your business can sell its products, and it also can be used to manage stock efficiently. For example, if your inventory turnover ratio is low, your business is possibly buying too much stock or there is a miscommunication between sales and purchasing departments.
To calculate your inventory turnover ratio, divide the average inventory by the cost of the inventory sold to determine how many times you had to restock over a certain period:
Inventory turnover rate = Cost of goods sold / Average inventory
Let’s say your average inventory value over the year was $10,000 and the cost of inventory sold was $97,000. The average inventory turnover ratio for the year is 97,000 / 10,000, or 9.7. In other words, you had to restock an average of 9.7 times over the year to keep up with sales.
The average turnover ratio indicates that sales were strong because you had to restock frequently. It also suggests that you might need to increase the amount of stock you purchase so you don’t have to restock as often.
2. Calculating the average inventory period
This calculation makes use of the inventory turnover ratio to determine how long items remain in inventory prior to being sold. You can find the average inventory period by dividing the number of days, weeks or months in the period, depending on the frequency you wish to use, by the inventory turnover ratio in that period:
Average inventory period = Time period / Inventory turnover ratio
Your annual inventory turnover ratio is 7.8. To determine the daily average inventory period, you’ll divide 365 by 7.8, which is 46.79. This means stock remains in inventory an average of 46.79 days.
In this example, the average inventory period indicates your stock is sitting on the shelf for more than a month at a time. A comparison with competitors will show whether your average inventory period is typical or unusual. If a period of 46.79 days is high, you should consider whether you need to increase sales or review your inventory management.
What Is Average Inventory on Balance Sheet?
In general, inventory is reported on the balance sheet as a current asset, which is expected to be converted to cash within a year. When inventory is sold, that cost is reported under the COGS on the balance sheet. And when that cost is a moving target, average inventory cost is helpful.
Average inventory isn’t always reported on balance sheets. It’s mostly used to calculate inventory turnover. And to generally contrast against demand planning, inventory forecasting, sales strategy, and purchasing habits.