Efficient inventory management is the backbone of the success of any business. For this purpose, businesses have several metrics that help them assess their performance and manage it accordingly.
Average Inventory is a metric that estimates the value of inventory during two or more time periods. Also, this can be used to estimate the total amount of inventory over these periods.
Average inventory value works best for businesses if it is calculated consistently over defined periods. In addition, this gives a long-term shot at inventory performance and can help in better management. Let’s understand in detail how to work out average inventory.
Why Calculate Average Inventory?
Every business owner knows that inventory is a fluctuating aspect of the business process. However, some businesses plan to stock products for a special occasion, for example, decoration items during Christmas or jackets during winter.
Keeping this in mind, calculating the average inventory can help businesses avoid stockouts, prepare for seasonal events, and provide a close estimate of the number of days’ sales of inventory (DSI). Let’s further explore how to calculate the average inventory:
How to Calculate Average Inventory?
The calculation of the average inventory uses the basic average formula, in which several values are added, and then the sum is divided by the total number of values.
Let’s first get to know the values to use for the average inventory calculation.
1. How to work out average inventory from balance sheet?
After learning how to find the average inventory on a balance sheet, you will need the following values to calculate the average inventory:
- Beginning inventory
- Ending inventory
- Number of periods
These values can be found in a balance sheet, making it easy to work out average inventory from the balance sheet. Let’s learn about them briefly below.
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Beginning Inventory
Beginning inventory is the value of inventory at the start of the period in consideration. For a new business, beginning inventory is also the initial inventory. This is the value of the inventory that the business purchased to begin operations.
For a business already in operation, the beginning inventory value is carried over from the previous period. This means that the value of the ending inventory of the previous year is the value of the beginning inventory of the period in consideration.
For example, if a business ends a period with $5,000 worth of inventory, the next period will begin with $5,000 worth of inventory, unless more is purchased.
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Ending Inventory
Ending inventory is the value of inventory at the end of the period under consideration. For this, a business needs to know the value of beginning inventory, additional purchases, and sales in this period.
This is the formula used to calculate ending inventory:
Ending Inventory = Beginning inventory + purchases – sales
For example, suppose a business began operations with $5,000 worth of inventory. In this period, inventory worth $1,500 was purchased. Till the end of the period, sales of $3,000 were generated.
Ending Inventory = 5,000 + 1,500 – 3,000
= 6,500 – 3,000
= $3,500
This shows that the business ended the period with $3,500 worth of inventory.
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Number of Periods
The number of periods suggests a time frame in which the value of average inventory is to be calculated. This period can be decided by businesses according to their requirements.
There is no rule that the average inventory should only be calculated between two time periods. For example, a business can determine the average inventory value over the course of three, four, five, and so on periods.
The unit of these periods can also be determined by businesses independently. For example, businesses may want to calculate the average inventory value of certain days, weeks, months, or even years.
Now that we have learned how to work out average inventory from balance sheet. Let’s learn how to calculate average inventory using these metrics.
2. Calculating Average Inventory
The formula for this calculation is as follows:
Average Inventory = Beginning Inventory + Ending Inventory/Time Periods
Let’s understand this with an example.
Suppose a wholesale shoes business wants to calculate the average inventory between the beginning and end of January. The business began the month with an inventory worth $20,000 and ended the month with $12,000 of inventory. The average inventory calculation will be as follows:
Average Inventory = 20,000 + 12,000/2
= 32,000/2
= 16,000
This shows that throughout the month of January, the business had an average inventory worth $16,000. The same average can also be calculated for a greater number of periods.
Suppose a business wants to calculate the average inventory for the first five months of the year. For this, the requirement is the actual value of inventory for each month.
Value of inventory in January = $20,000
Value of inventory in February = $18,000
Value of inventory in March = $16,000
Value of inventory in April = $14,000
Value of inventory in May = $12,000
In this calculator, the number of periods will be 5. Let’s add these values to the formula and calculate the average inventory.
Average Inventory = Inventory Value in Jan + Feb + Mar + Apr + May/No of Months
= 20,000 + 18,000 + 16,000 + 14,000 + 12,000/5
= 80,000/5
= 16,000
This shows that during the first five months of the year, this business held an average inventory value of $16,000. The same formula can be used when it comes to how to work out average inventory accounting. In this, several inventory products will be used instead of the inventory value.
How to work out the average inventory turnover ratio using the formula?
Inventory Turnover Ratio is the calculation of the time it takes for the business to sell the whole inventory since it was purchased. Average inventory is a useful metric to calculate the turnover ratio. Let’s check out how to work out the average inventory turnover ratio.
Inventory Turnover Ratio = COGS (cost of goods sold)/Average Inventory
Suppose the COGS of a leather belt inventory was $40,000, and the average inventory between the time period under consideration was $12,000.
Inventory Turnover Ratio = 40,000/12,000
= 3.33
This shows that the business sold its inventory for almost 3.33 times during that time period.
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Assessing the Future Trends
Calculating average inventory consistently over a period of time can help a business assess future trends. Average inventory shows how well or not adequately a business is performing.
When a business knows how much inventory it holds over a period of time, it can better predict how much will be required in the future to meet the targets.
Based on this calculation, a business can bring about the required changes in purchasing and managing the inventory.
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Resource Capacity Planning
Calculating average inventory can be helpful for a business in resource capacity planning. These resources can be the storage space, number of laborers, required tools, etc.
For example, if a business has average inventory values for the previous holiday seasons, they can plan for the upcoming one as well. If they want to purchase more inventory, they can rent extra storage space and hire more labor, etc.
Conclusion
Determining average inventory is a valuable tool for inventory management and sales/purchase planning. This not only allows businesses to assess their inventory’s worth but also determines how much is required to fulfill customer demands.
It’s worth mentioning again that the average inventory calculation can be fruitful only if done as a routine over time. The calculation is simple and can be done in a short time with clearly known values.
