Average Inventory Formula: Definition, Calculation & Usage Areas
A person who runs a business, no matter big or small, understands that inventory management is crucial for competitive warehousing and fulfillment success. But what is your beginning inventory number? How many items are coming to your warehouse? How many products have been sold last month? What is the deadstock ratio? If you are not sure of these answers, the average inventory formula can help.
Average inventory formula allows you to proactively monitor your inventory levels and safely manage your general stock. In this article, we dive into the average inventory formula, how to calculate it, and where to use it.
In this guide, we’ll help you understand:
- Understanding Average Inventory
- How To Calculate Average Inventory Formula?
- Where to Use the Average Inventory Formula?
- Issues with Average Inventory Formula
Understanding Average Inventory
Average inventory is the mean value of an inventory during a determined period. Thus, the average inventory requires a mathematical calculation. It estimates the value, or the number of goods stored on average within a given location. Businesses use average inventory information to determine how much inventory they have over a specific period.
Most companies calculate their stock levels at the end of the month or quarter. However, if you have a huge shipment arrive or move a large amount of inventory out through the end of that period, it can be disastrous to finalize calculations. That’s why the formula for average inventory takes a mean average over a longer period to form a clearer picture of your available inventory. But the average inventory can be used for other purposes, as well!
The two most common uses of average inventory are related to the comparison of sales and revenue. If you compare the average inventory of two separate periods, you will inevitably notice the fluctuations indicating a rise or fall in sales. On the other hand, if your company invests in generating certain revenues, the average inventory helps you predict the level of inventory your company needs.
In spite of those advantages, average inventory sometimes comes with a few drawbacks. Instead of a punctual one, it uses an average estimation, for detecting high volatility. And this can be important to eliminate ending inventory. For example, it is generally allowed the calculation to be based on a month-end inventory balance. However, it can be quite different if calculated on a day-end inventory balance. Another example is about yearly calculation. If you calculate business trends in the year-to-date calculation through the average inventory and if your sales are seasonal, this can lead to skewed distribution and misleading company executives.
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How To Calculate Average Inventory Formula?
Now that we have a clearer idea about what average inventory is and its pros and cons, it is time to talk about the actual formula. Here what it looks like:
Average Inventory = (Current Inventory + Previous Inventory) / Number of Periods
Let’s say that your current inventory value is $10.000, and your previous period’s inventory value is $30.000. The average inventory formula will be calculated according to those values like this:
Average inventory = ($10,000 + 30,000)/2
So, we have $40.000 divided by 2, which is equal to $20.000.
Average inventory calculation is this simple! And if you are working on more periods instead of two, just add all the other previous inventory amounts with the current inventory.
Let’s use another example to make the scene clearer. Consider that you are a market owner and want to see if the average inventory of the first semester of 2021 is accordant to the average inventory calculation for the first quarter of the year. The average inventory for the first quarter was $5000. It means that the value stored in the market warehouse in January 2020 was $5000 on average. The same value applied for February 2020 and March 2020. If you want to calculate the average inventory for the first semester, you need the month-end inventory figures for April, March, and June 2021. Your warehouse staff registered the following value:
- April 2020: $10,000
- May 2020: $5000
- June 2020: $12,000
The average inventory formula would be like this when we do the calculation:
AI (Average Inventory) = ($5000+$5000+$5000+$10000+$5000+$12000)/6 = $7000
As you can see from the result, the average inventory calculated for the semester is higher than the one calculated for the first quarter of the year. It means that the sales are quite good and the volatility is very low.
Where to Use the Average Inventory Formula
Now that you’ve seen how to calculate average inventory, let’s cover when to use it to better manage our business.
Inventory Turnover Ratio: One of the main reasons for understanding your average inventory is measuring your inventory turnover ratio. This is a measurement of how quickly your inventory is moving and helps you better understand how much inventory you need to have on hand at any given time. The formula for this measurement is as follows:
Inventory Turnover Ratio = (Cost of Goods Sold/Average Inventory)
Let’s make it more understandable with an example.
Say that you have $20.000 average inventory value, and $100.000 cost of goods sold. The formula looks something like this:
$100.000/$20.000 = 5
Your inventory turnover ratio here is 5. To understand if that’s a good or bad value depends on your business and the product being sold. However, generally speaking, higher ratios often show that you either have very strong product sales or do not keep enough stock available to meet the market demand. On the other hand, lower ratios mean the opposite. You are either not selling a lot of products or have too much stock on hand.
Average Inventory Period: This is another area where you can benefit from the average inventory level formula. To find that number, use the following formula:
Average Inventory Period = (Number of Days in Period/Inventory Turnover Ratio)
This calculation aims to help you better understand the time it takes to turn your inventory into actual sales. This calculation is also sometimes called the average days in the inventory formula.
Let’s take the turnover ratio we calculated above to set up the equation.
Average Inventory Period: (365/5).
In this example, the average inventory period is 73 days.
To understand if that’s a good or bad value, again, it is hard to say anything as it depends on your business and the product being sold. However, knowing how long an item stays in your warehouse is useful data to have when it comes to managing your inventory.
Issues with Average Inventory Formula
Calculating the formula for average inventory for your business can be a highly favorable move. However, it is also not without problems. Here below, there are some elements to consider before using the formula.
- Monthly & Daily Sales Fluctuations: Since the average inventory formula mostly considers data across a wide range of dates, there can be a great deal of variance between your daily inventory and the ones taken from larger periods. Similarly, most companies register their biggest sales numbers through the end of a certain period. That means that figures can be skewed, giving false impression of overall sales and productivity.
- Seasonal Fluctuations: For businesses whose product sales run seasonally, average inventory figures will also likely be inaccurate. This is particularly true for inventory levels. For example, if you are in high sales season, you’ll be carrying large amounts of inventory at the start of that period. Hopefully, that burden is significantly lessened by the end of that period. Although it is not a definitive reason not to use the average inventory formula, it is some other thing to be aware of when looking at your operational numbers.
- Estimated Balances: If you use the average inventory formula and base it off an estimated inventory balance instead of an actual count, the resulting numbers will most probably be a mess. In this scenario, problems arise because your starting numbers are based on approximations, rather than accurate numbers. And that means that your average inventory is based on an estimation, too.
After learning about the average inventory formula, you should be able to easily manage more accurate inventory operations. Inventory is the driving force behind your business, and the reason you are able to generate revenues and profit. Managing inventory cost-effectively will help you optimize your profits. It acts as a comparison tool and helps in analyzing the overall revenue generated by your business. That’s why the effort to calculate the formula is worth it because understanding the numbers can have an impact that affects your company’s bottom line. And this formula is a piece of cake! Using the formula in this article will have you tracking your inventory like a pro in no time.
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