Average Inventory Formula | How to calculate average inventory?
Whether you run a multinational or a micro-enterprise, you agree with me that a healthy inventory is a crucial ingredient of business success. Management of costs, sales, or even relationships all depend on it. So if you can keep a crisp inventory, there will be fewer hurdles for your business.
But what if my closing or opening inventories are not conclusive? Oh yes! You are right. Beginning or ending inventories are always limited and do not give a clearer picture of the stock status within a particular period. And this is where average inventory comes in.
What is an average inventory?
Average inventory is a calculated figure that represents the amount of a given set of finished goods or raw materials available within a specific period. Therefore, it is the mean inventory value for that period. It is derived from the starting and closing inventory values by getting the average of the two. Notably, average inventory is not the same as the median value of inventory for the given duration.
Understanding the concept of average inventory
The value of all items, either fully processed goods or raw materials, a company has in stock ready for sale comprises its inventory. If an enterprise wants to smoothen its relationships with suppliers, enhance sales, and manage costs, excellent inventory management is primary.
Change is inevitable, and every business is bound to have alterations in their inventories over time. However, such change cannot be precisely determined by only comparing inventory values at two different points with the period. Calculating the average inventory using several points provides a more accurate representation of the stock characteristics within a specified timeline. Look at the illustration below:
An electronics company wants to know their average inventory during a semi-annual stock-taking over the last six months. What is the best method of obtaining an accurate inventory change over the specified time? Here, we will use the ending inventory of every month plus the base month to calculate the average inventory. The reference points are seven (remember to include the base month for any other case). The values for all the points are summed up then divided by 7.
Did you get it? If not, let’s take this real-time example:
Having discovered a healthy inventory value, Jantez, an electronic company, wants to begin proper inventory management three months into the fiscal year. Their current stock value is $ 12,000, while the previous three months had inventory values of $9,800, $ 13,550, and $8,800. What is their 3-month inventory average?
The average inventory for the three months is obtained by adding $12,000, the current inventory value, to the previous inventory amounts and dividing them the sum by the total data points.
Avg Inventory = $ (12000 + 9800 + 13550 +8800) / 4
This gives an average inventory of $11037.5 for the past three months. The formula for determining average inventory can, therefore, be expressed as follows:
Average Inventory = (Current Inventory + Previous Inventory) No. of data points
The average inventory value can be determined as either inventory cost or level. Let’s get the difference between the two;
Average Inventory Cost
To obtain inventory costs, businesses assign a dollar value to every unit of their inventory. Therefore, the average inventory cost is determined by applying the unit cost to the opening and closing inventories. In short, the average inventory cost gives a monetary value of the inventory, and this marks its difference with inventory level.
Average Inventory Level
While the inventory cost utilizes each inventory unit’s monetary value, the inventory level only takes account of the number of units in the inventory. Therefore, finding the average inventory level will be much easier than its counterpart.
Generally, calculating the two are the same except in the last stage, in which average inventory cost has one additional step of introducing the unit cost.
Moving Average Inventory
This average inventory type can only be used by a business that keeps a perpetual inventory tracking system. It allows the enterprise to easily make inventory value adjustments based on the last purchase’s information, i.e., after every inventory purchase, the average inventory is recalculated. Consequently, a comparison of multiple stock averages can be made as you only need to convert all pricing to the existing market standard. Such a comparison is quite valuable for highly volatile goods.
Using moving the average inventory method to find average merchandise inventory gives an inventory cost between FIFO and LIFO methods. It is considered one of the most secure and stable means of finding average inventory cost since it is a middle-ground.
A periodic inventory system will not provide an accurate average inventory. A system only updates inventory costs at the close accounting periods, while the moving average requires real-time updates for a more accurate outcome.
There are average inventory calculators or software that can help with the computation using a moving average method. Without the software, the calculation will be an uphill task.
What is the relevance of finding average inventory?
Computation of average inventory provides a reference point for comparison of general sales volume and pattern. Therefore, it enables a company to track losses that might have occurred due to various reasons, including shrinkage, theft, damage due to poor handling, or expiry when dealing with perishables.
When using average inventory, a business can deduce its purchase and sales trends, thereby planning its inventory accordingly. This averts issues of both stock-outs and excesses that may put the company finances on the line.
The average inventory is used to obtain some practical business parameters that make the deductions as mentioned earlier. These include:
- Inventory turnover ratio
The inventory turnover ratio is obtained by dividing the cost of goods sold (COGS) by the average inventory. It is expressed as follows:
Inventory Turnover Ratio = COGS / Avg Inventory
This ratio is an indicator of a company’s sales rate. A higher ratio has two implications. Either the company has robust sales or inadequate inventory. The latter translates to indirect losses. On the other hand, a lower ratio may imply that the company sales are relatively low due to lack of demand or excess inventory.
Excess inventory means the company will hold the inventory for a more extended period, which becomes a liability. You risk increasing costs in storage, labor, and more, to say having an obsolete inventory!
Determining Inventory Turnover Ratio
Using the previous illustration, if the cost of goods sold (COGS) for Jantez amounted to $ 12500, then the turnover ratio would be calculated as follows;
COGS= 12500 and average inventory = $11037.5.
Inventory turnover ratio = 12500/11037.5
This gives a ratio of 1.13, which is relatively low, indicating that the company sales might be weak.
- Average Inventory Period
Another parameter derived from an average inventory, though indirectly, is the average inventory period. It is calculated from the inventory turnover ratio, and it points out the time taken to convert products into sales.
Average inventory period = No of days within the period / Inventory turnover ratio
In the case above, Jantez has an inventory turnover ratio of 1.13, and assuming the days are 90, and we can compute the average inventory period, as shown below:
Average Inventory Period = 90/1.13
The avg inventory period here is 79.64.
How To Find Average Inventory
Determining average inventory is one of the most straightforward accounting calculations. Below are some of the methods you can use.
Average Inventory Equation
If you want to determine the avg inventory across a given period, here is the formula:
Average inventory = (Starting Inventory+ Ending Inventory)/
While this is the most popular method, there is another way of average inventory calculation per period. For instance, you can compute the average inventory per year, month, or even week. It is what we had alluded to earlier, and here is the formula:
Average Inventory = (Opening Inventory + Closing Inventory) / No of the period
Now let’s go to the illustrations, and we will still use our example of Jantez Ltd. Our aim here is to find the average inventory for Jantez in 1 year (12 months) using the first method.
But first, did you note something common for the two formulae? They both utilize opening/beginning and closing/ ending inventory. So how do we obtain these? See below:
Calculating Beginning Inventory
With proper inventory management, opening inventory is the same as the ending inventory for the last accounting period. However, if you have no clear inventory records, you can use the formula below to calculate the starting inventory.
Opening Inventory = (Current Closing Inventory + Cost of Goods Sold) – Inventory Bought
Note: These values, closing inventory, COGS, and inventory bought, for the period in question can be obtained from the accounting records.
Consider this example: In the year 2019, Jantez Ltd had a closing inventory cost of $ 5,000, COGS of $3500, and $ 2200. What was the beginning inventory for the same year?
Beginning inventory = (closing inventory + COGS) – purchased inventory
$ (5000 + 3500) – 2200
Calculating Closing Inventory
For the ending inventory, the equation would be as follows:
Ending Inventory = (Opening inventory + purchased inventory) – Cost of goods sold (COGS)
For instance, during the past fiscal year, Jantez Ltd’s beginning inventory was $ 6,300, and the purchased inventory was $ 2,200, while the COGS was $ 3,500. What was their ending inventory?
Ending inventory = (starting inventory + inventory purchased) – COGS
= $(6,300 + 2,200) – 3500
Having learned how we obtain these two critical values, let’s look at calculating average inventory cost examples.
For the year 2019, the beginning inventory for Jantez Ltd was $6300 while the ending inventory was $5000. Therefore, the average inventory would be:
Average inventory = $ (6300+5000) / 2
= $ (11300 /2)
= $ 5650
Averagely, the inventory Jantez Ltd had on hand throughout 2019 was $ 5650. This is the average inventory cost for this company. However, if we were to consider only the number of electronic devices in their store without including the unit price, we would calculate the average inventory level.
For the second formula, in which we calculate the average inventory per period, we will add the ending inventory for every month and divide the sum by the number of periods.
Example: Jantez Ltd had the ending inventories for June, July, and August as $ 18,500, $ 21300, and $14200, respectively. The average inventory for the three months would be determined as follows:
Avg Inventory = (18500+21300+14200)/3
Simple! That is how you calculate the average inventory. But will this appear on the balance sheet or the ledger? We leave no stone unturned, so read on and understand the average inventory in accounting.
Average Inventory Accounting
The average inventory does not appear directly on the balance sheet. However, it is recorded as the current asset. This is supposed to be converted to cash within the fiscal year. Once the inventory is sold, the cost is recorded on the balance sheet under the cost of goods sold(COGS) section. The average inventory cost is more valuable if the cost is a moving target.
Even though the average inventory is never reported in the balance sheet, it is utilized in determining the inventory turnover ratio, as mentioned earlier. Consequently, it is helpful when performing demand forecasts, evaluating sales strategy, and purchasing trends.
Have you ever heard of inventory smoothing? It is the product of the average inventory. Average stock inventory allows a company to make particular strategic decisions without the risk of considerable fluctuations in cost or even getting outliers.
After identifying the most consistent inventory values, a business can minimize risks associated with specific inventory purchase trends and selling patterns. For instance, operations that are likely to produce inflated inventory carrying costs are avoided while embracing those associated with higher selling rates.
It would be best if you had inventory management software and a perpetual inventory to achieve inventory smoothing. The calculation should be automated as it is quite bulky.
Limitations of Average Inventory Formula
- Ending inventory may be biased. The formula uses ending inventory to calculate the average inventory, and in most cases, the closing inventory does not provide a precise representation of the inventory throughout the interest. For example, most companies have their product promotions at the end of the year, which attract more than the usual sales. Their end inventories may therefore be much lower than those seen in the rest of the year. In such a case, the average inventory would also be biased.
- Not suitable for seasonal sales. For businesses that experience a boom in sales during particular seasons, average inventory is not a useful tool for evaluating and planning their operations. After the peak seasons, the inventory balance would be relatively low while abnormally high in the off-peak. This phenomenon is expected in the textile industry, depending on the weather seasons.
- Ending inventory balance estimation. Instead of providing actual inventory balance by performing physical counting of the units in-store, most enterprises use estimates. This further reduces the accuracy of the average inventory, which is already likely to be biased.
Despite the limitations of average inventory, it provides useful information when carrying comparisons between the inventory and the revenue. Typically, the income statements contain both monthly and year-to-date revenues. Comparison is usually made between the average inventory balance and the year-to-date revenue to determine how much capital was used to realize the sales.
Final thoughts and Key Takeaways
- Average inventory is the mean value of inventory an enterprise holds over a specified time frame, which is always long.
- It is computed as the average inventory level at the beginning and end of an accounting period.
- Avg inventory is essential when making comparisons between the inventory level and revenue. It provides essential information on the amount of investment required to drive a particular amount of sales.
- The business performance or in and out movements of inventory can be evaluated following inventory holding. It can even offer better grounds for making informed decisions in planning and strategy development.