Formula to Calculate Average Inventory
Average Inventory Formula is used to calculate the mean value of Inventory 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 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 takes care of such spikes as it takes the mean value of both the Beginning and Ending Inventory.
The above formula is one of the simplest ways for the calculation of the Average Inventory which is used to avoid the effect of sharp spikes or drops in the 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 the 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 (with Excel Template)
ABC Limited reported the following details pertaining to its Inventory levels as on 31.03.2018.
Avg Inventory-
Use and Relevance
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. It helps in the computation of various useful ratios, namely:
#1 – Inventory Turnover Ratio
One of the important ratios which use Avg 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.
Example of Inventory Turnover Ratio
Continuing with the above-given example 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:
= ($128000/$16000) = 8
#2 – Avg. Inventory Period
Another important ratio that makes use of Inventory Turnover Ratio and allows management to understand the time taken in converting goods into sales.
Example of Avg 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 avg Inventory Period as follows:
= (365/8) = 45.63
Average Inventory Calculator
You can use the following calculator.
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Issues with Average Inventory Formula
- One of the major issues is it’s calculated based on Ending Inventory Balance of the period which may not be a true representative of the Average of the period.
- It 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 Avg Inventory will result in loss of sales during peak season time and excess Inventory during the non-peak period. Examples include companies in Woolen Industry etc.
- The 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
- It is used to measure the amount of Inventory which 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 Avg. Inventory helps in analyzing how much Inventory Investment is required to support a given level of sales for the business.
- Inventory becomes more relevant in case of businesses that 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.
- Inventory Holding provides various exciting 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 the Average Inventory Formula. Here we learn how to calculate Average Inventory using its formula along with its uses, practical examples and calculator. You can learn more about Accounting from the following articles –
