Understanding how to calculate Average Inventory and all the associated concepts is a crucial skill and a backbone to keeping the business operating. Determining the optimal amount of inventory to keep in stock is a delicate balancing act. Too much will turn into immense costs. Too little and you will not be able to satisfy the demand for the product.
Keeping track of average inventory is a vital aspect of inventory management and essential to running a smooth business operation. The calculation of average inventory helps businesses determine the amount of stock they require to run their daily activities without a hitch. The measure is a good indicator of the business’s needs and clearly represents if there are any adjustments needed to be done to the production or purchasing strategies that the company is employing.
Moreover, management can use average inventory to examine if there are any trends in sales. It is a good determinant for evaluating sales rates and sales volumes – by comparing the average inventory number to the generated revenue in the same time period, one can determine the amount of stock necessary to support the sales.
Finally, average inventory calculation can decrease costs by helping management make decisions concerning resource capacity planning. On one hand, a company may need to expand its storage space and hire more workers to avoid stock-out. On the other hand, holding an excess stock can incur a lot of costs starting from holding facility costs, tied-up capital, and ending with the possibility of inventory damage (for example food can get spoilt).
This article will provide a detailed explanation of how to calculate average inventory and how to use the results for further analysis.
Definition
To explain it simply, average inventory estimates the amount or the value of inventory a company keeps in stock over a certain period. One can calculate it with the following formula:
Average inventory = [(Beginning inventory) – (Ending inventory)]/ 2
Or for longer periods and more precision:
Average inventory = [(Beginning inventory) – (Ending inventory)]/ Number of accounting periods
- Beginning Inventory – Beginning inventory is the amount or the value of items you have in stock at the beginning of the accounting period. It is equal to the ending inventory of the previous accounting period.
- Ending Inventory– Ending inventory is the account of goods still available for sale, or still in stock, that the company has left at the end of the accounting period. It is calculated by:
Ending inventory = Beginning inventory + Purchases – Cost of goods sold
One important note to keep in mind is that the average inventory can either be calculated based on the physical amount of inventory in stock or its monetary value of it.
Example 1
Lukas is working in a breakfast café. He was recently promoted and assigned new responsibilities. One of his tasks includes keeping track of and planning for the stock of coffee beans that they keep. He has to decide how many packages of coffee beans to order for the next quarter. He knows that they started the quarter with 5000 packages and have only 760 left. He decides to calculate the average inventory:
Average Inventory =
Thus, Lukas found out than on average they had 2880 packages of coffee beans in the storage during the quarter.
Example 2
Anna has recently opened up a restaurant. However, she is suffering some losses. This is due to the fact, that she bought a lot of food supplies in advance to keep in stock. However, she overestimated the amount of demand and some of the ingredients are soon going to be out of date. Now, she wants to stock up better, so she decided to calculate the average inventory based on the values of inventory in the last six months.
| Month | Inventory |
| January | $ 5400 |
| February | $ 4300 |
| March | $ 3100 |
| April | $ 2000 |
| May | $ 1100 |
| June | $ 250 |
To calculate the average inventory, we just need to sum up the values of inventory in each month and divide by the amount of time periods.
Average inventory =
= $ 2691.7
What is the Average Inventory used for?
Calculating the average inventory can provide a person with useful information. It is a way better indicator to use for planning and decision-making than simply looking at the current inventory. This is because the average inventory nullifies the possible sharp spikes and fluctuations the ending inventory may have by using the values at both the beginning and the ending periods.
However, this is not to say that the average inventory is dependable. After all, it is merely an estimate. Generalizing such a number and using it for planning purposes over long periods can backfire and lead to an inflexible strategy.
For example, it can be especially detrimental for companies that operate seasonally or based on trends. If they use the average inventory as a measure to plan for the whole year, they may suffer excess inventory when their product is out of season and have a shortage when it is in season. Nevertheless, average inventory is usually calculated to determine other indicators. For example:
Inventory Turnover Ratio
The inventory turnover ratio is used by management to determine how efficient the company is in processing and managing the inventory. It showcases how quickly inventory moves along, or more simply put how quickly your inventory is being sold. We can use the following formula:
Inventory turnover ratio = COGS / Average inventory
This number can also showcase whether a company is doing well or not. A high turnover ratio means that the demand for the product is high, the sales are smooth, and thus, the company needs to replenish often. On the other hand, a lower turnover rate indicates that the company may not be efficient with managing stock; Then, the company may need to reconsider its strategies.
DSI/DIO
Another calculation that the average inventory number is used for is Days Inventory Outstanding (DIO) or also called Days sales of Inventory (DSI). This measure indicated how many days it takes for the company to sell its inventory. It can be calculated using the following formula:
DIO = [Average Inventory/ COGS] x 365 days
The interpretation and the number of DOI may vary depending on the business and the economic environment. However, in general, lower numbers of DOI are better.
Additional Note
Companies may use different inventory processing systems. Some companies use the periodic inventory method, where the inventory is accounted for at specific periods. These periods are usually monthly, quarterly, or most often yearly. This method is mostly suitable for companies who do not need to keep an accurate stock estimate of inventory.
On the other hand, some companies use perpetual inventory processing methods. This mean, companies keep track of changes in inventory in real time. This is made possible, through the use of inventory management software that helps keep track of inventory movement live.
