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What is Average Inventory Formula?
Average Inventory Formula is the mean value of Inventory which is calculated at a certain point of time by taking the average of the Inventory at the beginning and at the end of the accounting period. It helps management to understand the Average Inventory the business needs to hold during its daily course of business.
Since Ending Inventory can be impacted by a sudden drawdown of Inventory or a large supply of Inventory, therefore Average Inventory takes care of such spikes as it takes the mean value of both the Beginning and Ending Inventory.
The formula for the calculation of Average Inventory is as follows:
The above formula is one of the simplest ways for the calculation of Average Inventory which is used to avoid the effect of sharp spikes or drops in Ending Inventory as it involves taking Average of Beginning and Ending Inventory.
Inventory is the driving force behind the ability of a business to generate revenues and resulting profit and managing Inventory in a cost-effective way helps business to optimize their profits. It acts as a comparison tool and helps in analyzing overall Revenue generated by the business from the context of Inventory utilization (Holding Inventory for long also results in a cost for business in the form of storage cost, labor cost and also the business carries the risk arising on account of Inventory becoming obsolete, rotted etc.)
Example of Average Inventory Formula (with Excel Template)
ABC Limited reported the following details pertaining to its Inventory levels as on 31.03.2018.
Based on the above-given data the calculation of Average Inventory formula can be done as follows –
Average Inventory-
Therefore, Average Inventory as on 31.03.2018 is $16000.
Similarly business can do the calculation of Average Inventory based on monthly Inventory Balances as well which will give a better picture on the Average Inventory of the business over the period and will take care of seasonality factor as well.
Importance and Usage of Average Inventory Formula
Average Inventory Analysis helps management to understand its Purchase pattern and Sales trend which helps them in better planning of Inventory to avoid the problem of stock outs and also to avoid the cost of carrying excess Inventory as that can result in strain on the finances of the company. Further Average Inventory formula helps in the computation of various useful ratios namely:
#1 – Inventory Turnover Ratio
One of the important ratios which use Average Inventory to understand how fast a company sells its Inventory whereby a higher ratio implies either strong sales or insufficient Inventory resulting in loss of business and a lower ratio implying weak sales, excess Inventory or lack of demand for the company’s product.
The formula for the calculation of Inventory Turnover Ratio is given by the following equation:
Example of Inventory Turnover Ratio
Continuing with the above-given example of Average Inventory formula let’s assume ABC Limited made a $200000 in Sales and $128000 in Cost of goods sold (COGS). Using the data we can compute the Inventory Turnover Ratio as follows:
By using the above data, calculation of Inventory Turnover Ratio can be done as –
i.e. Inventory Turnover Ratio= ($128000/$16000) = 8
Therefore, Inventory Turnover Ratio = 8 times
#2 – Average Inventory Period
Another important ratio which makes use of Inventory Turnover Ratio and allows management to understand the time taken in converting goods into sales.
The formula for the calculation of Average Inventory Period is given by the following equation:
Example of Average Inventory Period
Continuing with an above-given example where ABC limited has an Inventory Turnover Ratio of 8 times. Using the data and assuming the period of 365 days we can calculate the Average Inventory Period as follows:
By using the above data, calculation of Average Inventory Period can be done as –
i.e. Average Inventory Period= (365/8) = 45.63
Therefore, Average Inventory Period = 45.63 days
You can download Average Inventory Formula Excel Template here – Average Inventory Formula Excel Template
Average Inventory Formula Calculator
You can use the following Average Inventory Calculator.
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Issues with Average Inventory Formula
- One of the major issues with the Average Inventory formula is its calculated based on Ending Inventory Balance of the period which may not be a true representative of the Average of the period.
- Average Inventory formula is not a good estimation tool for business which is seasonal in nature as such company’s sales are impacted by their seasonal shifts and any Inventory planning based on Average Inventory will result in loss of sales during peak seasonal time and excess Inventory during the non-peak period. Examples include companies in Woolen Industry etc.
- Majority of the business provides an estimate of Ending Inventory instead of making an exact Inventory count which again results in affecting the calculation of Average Inventory which itself is based on the Mean of Beginning and Ending Inventory.
Final Thoughts
- Average Inventory equation is used to measure the amount of Inventory which a business usually holds over a longer time period frame. It is simply the average between the Inventory level reported during the Beginning of the measurement period and during the end of the measurement period. It holds relevance as the Income Statement (covers a period of time) and the Balance Sheet represents the position as on a particular date only. As such when comparing the business Sales level with its Inventory level it makes sense to use Average Inventory which helps in analyzing how much Inventory Investment is required to support a given level of sales for the business.
- Average Inventory becomes more relevant in case of businesses which are seasonal in nature and needs to build up more Inventory than the usual Average of the rest of the non-seasonal period to make up for the increased demand during peak season.
- Thus Average Inventory levels and various Inventory ratios such as Inventory Turnover Level, Average Inventory Holding etc provides various interesting insights into the performance of a company and the movement of Inventory in and out of the business which can further dwell into by the management to make better-informed business decisions.
Recommended Articles:
This has been a guide to Average Inventory Formula. Here we discuss how to calculate Average Inventory using its formula equation and its uses along with practical examples. You can learn more about Accounting from the following articles –
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