average-inventory-formula

Average Inventory Formula: Definition, Calculation & Usage Areas

A person who runs a business, no matter big or small, is aware of the fact that inventory management is crucial to reach success. What is your beginning inventory number? What is the number of items coming to the warehouse? How many products sold that month? What is the deadstock ratio? If you use an average inventory formula you’ll be able to monitor your inventory levels better and feel safe about your general stock situations. In this post, we dive into the average inventory formula, how to calculate it, and where to use it.

In this guide, we’ll help you understand:

  1. Understanding Average Inventory
  2. How To Calculate Average Inventory Formula?
  3. Where to Use the Average Inventory Formula?
  4. Issues with Average Inventory Formula

Understanding Average Inventory

The 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. The businesses use average inventory information to determine how much inventory they have over a specific period. Most of the 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 the calculation. That’s why the formula for average inventorytakes a mean average over a longer period to form a clearer picture of your available inventory. Moreover, the average inventory can be used for different purposes. The two most common usages are related to the comparison of sales or revenue. On one hand, if you compare the average inventory of two separate periods, it is inevitable for you to notice obvious fluctuations due to a rise or a fall in sales. On the other hand, when companies invest in generating certain revenues, the average inventory steps on the scene since it helps understand the level of inventory that company needs.

Apart from those advantages, average inventory sometimes comes with a few drawbacks, too. Instead of a punctual one, using an average estimation, 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.

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Let’s make another example to make the scene clearer for you. Consider that you are a market owner and want to see if the average inventory of the first semester of 2020 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 2019 and March 2019. If you want to calculate the average inventory for the first semester, you need the month-end inventory figures for April, March, and June 2020. 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

After seeing how to calculate average inventory, now let’s see 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 goes like this:

$100.000/$20.000 = 5

Your inventory turnover ratio here is 5. To understand if that’s a good or bad value, it is hard to say anything because it really 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 vice versa. 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. Here’s the formula to find that number:

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.

Avarage-inventory-formula

Issues with Average Inventory Formula

Calculating the formula for average inventory for your business can be favor in many aspects, However, it is also not without problems. Here below, there are some clues for you 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. So, the figures can be skewed, and you will have a false impression of overall sales and productivity. Shortly, along with not being a strong reason not to use the average inventory formula, it is something to factor into your thinking when you use the calculation.
  • Seasonal Fluctuations: In the businesses where product sales run seasonal, average inventory figures can be delusional. This is also particularly true for your 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, the burden you carry at the end of the same period will be significantly less. Again, along with not being a strong reason not to use the average inventory formula, it is some other thing you should be aware of when looking at your 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 in a mess. In this scenario, the problem arises because your starting numbers are based on an approximation. And that means that your average inventory is based on an estimation, too.

After seeing all these about the average inventory formula, you can easily apply it to your business for more accurate inventory operation, which is quite important for a company. Inventory is the driving force behind the ability of a business to generate revenues and profit. Managing inventory cost-effectively helps companies optimize their profits easily. It acts as a comparison tool and helps in analyzing the overall revenue generated by the 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 track your inventory like a pro in no time.

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