Average Inventory: What It Is & How To Calculate It?
As a business owner, successful inventory management is perhaps one of the most important aspects of running a company. If you have too much inventory on hand, it’s an indication that you have money tied up in unnecessary goods.
Too little, however, and you risk losing out on sales opportunities. But when your average inventory is well balanced, your business will thrive. What’s more, a good balance of inventory reflects your managing skills and shows that you have a good grasp of what it takes to run a successful business.
Find out how you can ensure proper average inventory with this guide. Here, you will learn how to calculate your average inventory so you can stay ahead of the curve.
Here’s What We’ll Cover:
What Is Average Inventory?
We know that inventory consists of anything your business sells or uses. This can be anything from finished products to raw materials. Average inventory, on the other hand, focuses on estimations. Such estimations concern the quantity or value of your inventory in specific periods of time.
Your inventory balance may fluctuate greatly at the end of each month. These fluctuations depend on a few key factors, including:
- When you receive a large number of goods
- When there is a huge sales push
- When there is a peak season
Each of these factors significantly impacts your inventory in one way or another. The average inventory calculation can balance this sudden peak in any direction. Plus, it can provide a more stable indicator of your inventory’s readiness.
Average inventory is the calculation of the average inventory count for two or more accounting periods. To calculate the average inventory for a year, add the inventory quantities at the end of each month and divide by the number of months.
Remember to also include the base month in the calculation of the average inventory for the fiscal year. This also means that you need to divide the total by 13 months instead of 12 months. The average inventory data for other time periods are also calculated in a similar way.
This is an average method of comparison using your inventory. Compare the previous fiscal year revenue with the average inventory for the same period. This will show how much inventory you need on average each month to supply and support that sales volume. You can perform the same exercise in any given time period, such as year to date or by month.
Why Is Average Inventory Important?
Every business’s inventory fluctuates. You may receive a large number of deliveries at the end of certain months. You may also be stocking up on inventory in preparation for a sale. Or, your business may be seasonal, offering items typically purchased during certain times of the year. Viewing one period doesn’t necessarily present an accurate understanding of your current inventory.
It is important to consider the big picture when planning. So think about this any time you negotiate with suppliers and strategize on your inventory orders. Also, think about the total inventory you need to have on hand to support sales to fund your bottom line. Using the average inventory formula can give you an overview of a specific period.
Average inventory also plays a vital role in understanding how soon you can convert inventory to sales. You can achieve this through DSI (days sales of inventory) and inventory average turnover ratio.
Average Inventory Formula and Inventory Average Turnover Ratio
Inventory turnover is a method to see how long it takes to sell inventory from the time you buy it. Plus, it shows whether you hold too much inventory. If your turnover rate is high, it means you are moving products and replacing inventory.
But if you do not hold enough inventory to meet demand, it can indicate that you are losing sales. You can benchmark your company’s ratio by comparing it to peer companies. This will give you an idea of how well you are performing.
Need to calculate your inventory average turnover ratio? You must first find out your inventory average and your COGS (cost of goods sold). This is a measurement of your inventory costs for producing goods, which includes both labour and materials.
You can usually find it in your income statement. Once you have the information you need, use the following average inventory calculation:
COGS ÷ average inventory = inventory turnover ratio
DSI is simply a measurement of how long it takes to sell your inventory. Have your average inventory handy for this formula.
Average inventory ÷ COGS x 365 (days of inventory sales) = DSI
If possible, you want a lower DSI. But keep in mind that this varies by industry, just like your inventory average turnover ratio. You can get a ballpark of where your DSI should be by researching peer companies in your industry.
Now that you know how to calculate DSI, let’s look at the average inventory formula. You can adjust this formula so that it covers a larger time period if you wish.
Current period inventory + previous period inventory ÷ number of periods = average inventory
Let’s assume that your closing inventory values for July through September are as follows:
Your average 3rd Quarter inventory is the total above divided by the total number of months. Therefore:
Average inventory = $1,350,000 ÷ 3 = $450,000
By using these formulas in your business, you can maintain an ongoing record of your inventory. You can then make adjustments where necessary to ensure an optimal balance of goods purchased.
Keep in mind that certain seasons might present inaccurate figures. As such, you’re likely to have both high and low variances at times. For most of the year, though, you shouldn’t have any trouble maintaining an accurate average inventory figure.
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