If you’re running a business, odds are you know how important inventory management is to your success. Without proper management, retailers and warehouses never have a truly accurate account of all the things they have in stock, which can be disastrous from a customer service perspective.
Using an average inventory calculation, you’ll be able to better monitor inventory levels and stock flow through your business. Today, we’ll dive into what average inventory is, and how using the average inventory formula can help you better manage your business.
What is Average Inventory?
If you’re looking for a working average inventory definition, this one sums it up nicely.
Average inventory is a calculation businesses utilize to determine how much inventory they have over a specific time period.
Many companies count their inventory at the end of the month or quarter or other period of time, but these numbers can be easily skewed if you have a huge shipment arrive or move a large amount of inventory out close to the end of that period.
The average inventory method takes a mean average over a longer period of time to create a clearer picture of how much inventory is normally on hand.
One of the benefits of using the average inventory calculation is that when coupled with revenue statements, it becomes much easier to determine how much inventory a company needs to have available to support sales. Carrying too much or too little inventory can be detrimental to your business and the bottom line.
Understanding the Average Inventory Formula
Now that we know what average inventory is and have a better understanding of how companies use it, let’s talk about the actual formula that you’ll need to make this important calculation.
If you’re not a big fan of mathematical computations, don’t worry. This one’s pretty simple. Here’s the formula:
Average Inventory = (Current Inventory + Previous Inventory) / Number of Periods
So, as an example, say your current inventory value is $20,000.
Your previous period’s inventory value was $30,000.
And we’re trying to figure out the average inventory value for these two periods.
Thus the formula would look like this:
Average inventory = ($20,000 + 30,000)/2
So, we get $50,000 divided by two, which equals $25,000.
See? Told you it was simple.
And really, that’s it. That’s the formula. If you want to do more than two periods, just add in all the other previous inventory amounts with the current inventory.
When to Use the Average Inventory Formula
Now that we know how the formula works, let’s talk about when you should be using the average inventory formula for your business.
1. Inventory Turnover Ratio
One of the main reasons for understanding what your average inventory is, is to measure your inventory turnover ratio. This is a measurement of how quickly (or how slowly) your inventory is moving and allows you to better understand how much inventory you need to have on hand at any given time.
The inventory turnover formula for this calculation is as follows:
Inventory Turnover Ratio = (Cost of Goods Sold/Average Inventory)
For this example, we’ll take our $25,000 average inventory from the previous example.
And to keep the math simple, let’s say the cost of goods sold is $100,000.
$100,000/$25,000 = 4
Your inventory turnover ratio here is four.
If you’re asking if that’s a good or bad ratio, that really depends on your business and the product being sold. Generally speaking, higher ratios indicate you either have very strong sales of the product or aren’t keeping enough stock on hand to meet demand (and in some instances, both). Lower ratios mean you’re not selling a lot of the product or that you have too much stock on hand.
2. Average Inventory Period
The next calculation where the average inventory number is useful is in determining the average inventory period. Here’s the formula to find that number.
Average Inventory Period = (Number of Days in Period/Inventory Turnover Ratio)
The point of this calculation is to help you gain a better understanding of the time it takes to turn your inventory into actual sales. This calculation is also sometimes called the average days in inventory formula.
Taking the turnover ratio we calculated above, we can set up the equation. Here’s an example of how it works:
Average inventory period = (365/4).
In this example, the average inventory period is 91.25 days.
Again, what a good average inventory period is will vary depending on your company and product. However, understanding how long items sit in your inventory is a useful piece of data to know when it comes to managing your inventory moving forward.
Why Should I Use the Average Inventory Formula?
Earlier in this article we touched on some of the reasons why using the average inventory formula can be beneficial for your business. The key takeaway is that it can help you have a better understanding of the amount of inventory you’re carrying and whether or not those amounts are too high or too low.
Beyond that, the average inventory formula will help you gain insights into the following:
- Overall sales volume
- Inventory losses related to shrink and theft
- Inventory loss due to damages
- Inventory loss due to expired product
- Inventory turnover
These are just some of the things you can glean from using the average inventory formula. The values provided can impact your inventory management in a wide variety of ways.
Problems with Average Inventory
Like so many things in life, using the average inventory can be a boon to your business, but it’s also not without its issues. Here are some things to consider before you use it.
Variations between monthly and daily sales
Since the average inventory formula mostly considers data across a wide range of dates (months, quarters, or arbitrarily selected sales periods), there can be a great deal of variance between your daily inventory and the ones culled from larger time periods.
By this same token, many companies make their biggest sales pushes at the end of a period, so the numbers may skew, giving you a false impression of overall sales and productivity.
This shouldn’t be construed as a reason not to use the average inventory formula, but is something to factor into your thinking when you do.
Fails to account for seasonal fluctuations
If you’re a business where sales can ebb and flow with the seasons, average inventory figures can be misleading.
This is particularly true of your inventory levels. If you’re coming into your big season, you’ll undoubtedly be carrying more inventory at the start of that period. Hopefully you’re also carrying significantly less at the end of the season.
The broad nature of the formula really doesn’t take these seasonal fluctuations into account. Again, this is not something that should keep you from using average inventory figures, but instead another thing you should be aware of when looking at your numbers.
Relies on estimated balances
This one doesn’t apply to everyone, but if your company uses the average inventory formula and bases it off an estimated inventory balance and not an actual count, that can throw your numbers into disarray.
In this scenario, the problem arises because your starting numbers are based on an estimate, meaning your average inventory (which is already an estimate) is based on an estimate. You can see where this could muck things up.
Again, this is not a deal breaker when it comes to using the average inventory formula – but just something to consider as you do your computations.
Moving Average Inventory
If you’re using inventory management software and a good point of sale system, you may consider utilizing a moving average inventory system.
Because modern technology makes it possible to track inventory in real-time with each transaction, a moving average inventory can be constantly updated automatically with each sale.
The benefits of the moving average inventory approach include:
- Ability to compare inventory averages across multiple time periods
- Ability to better compare items that have more volatile sales patterns
The biggest benefit of using the moving average approach is that it makes it much easier to calculate the average cost of goods sold.
Inventory management is an important job for many businesses, and it can seem like a daunting task.
The effort is worth it, though – because as the average inventory formula demonstrates, understanding the numbers can have an impact that affects your bottom line.
The best part is that figuring out your average inventory (and all of the other things you can calculate using that number) is generally simple. Using the formulas we’ve highlighted in this article will have you tracking your inventory like a pro in no time.
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