Average Inventory

What Is Average Inventory?

Average Inventory is the mean value of a company's stock over a specific period, crucial for financial analysis and planning. It estimates how much Inventory a business has over a specific time. 

Inventory balances at the end of each month are subject to large fluctuations depending on when large shipments arrive and when a buying surge or peak season brings down inventory levels significantly.

Indicators of inventory readiness are more stable with their calculation, which evens out the sudden fluctuations in either direction. An analysis of inventory items averaged over two or more accounting periods is known as average Inventory. 

Add inventory counts at the end of each month and divide by the number of months to get it over a year. 

Remember to include the base month in your fiscal year's calculations, dividing the total by 13 instead of 12. The average figures for other periods are calculated in the same way.

Inventory management is critical for controlling costs and ensuring customer satisfaction. However, when too much Inventory is on hand, capital is being held up unnecessarily and may even be jeopardized.

For example, some perishable, trendy, or seasonal items may not last long. Therefore, a lack of Inventory can result in lost sales opportunities and empty store shelves.

The right amount of Inventory propels a business forward and reflects its strengths in cost management, sales, and business relationships. Accounting can use a formula to track changes and activities over time.

Understanding Average Inventory

When looking at a company's inventory status, this lens is often preferable to a single point in time or accounting period. The total amount or value of your Inventory averaged over two or more accounting periods is called average Inventory.

It is the average value over a while. That value might or might not be the same as the median value calculated from the same data. However, the average can be used for meaningful comparisons to other data points. 

For example, someone can track inventory losses due to shrinkage, damage, and theft by comparing the average to overall sales volume in the same period.

Average Inventory Importance

Average is a company's inventory calculation over an approximate or estimated time. Receiving oversized shipments, a surge in sales, and other factors can affect inventory balances at the end of the month as they replenish or deplete Inventory.

Calculating the average level eliminates the swings on either ide and gives a more accurate picture of inventory availability.

The average determines how quickly you can convert Inventory into sales. The inventory turnover ratio and the days' inventory sales, or DSI, are used to accomplish this.

A variety of factors can cause inventory stock fluctuations. For example, while a large delivery can cause an increase in Inventory, a sales surge during peak season can deplete someone's stock. 

Seasonal businesses are especially susceptible to fluctuations. These factors, however, are only temporary, and you cannot base your inventory stock decisions on them. It is why having a good average is crucial. Some of the importance are:

1. Average Inventory allows someone to plan how much stock anyone will need for their business ahead of time.
2. It also aids in the tracking of inventory losses caused by inaccuracy, expiration, shrinkage, theft, or accidents.
3. The inventory turnover ratio and average period can be extremely useful in determining and evaluating how long your company takes to sell Inventory.
4. Accounting firms that use the perpetual inventory method maintain a continuous real-time inventory record.

Example of Average Inventory

To calculate the average, add beginning and ending inventories. Then, divide the total by two. The formula is

Average inventory = (Beginning inventory + Ending inventory) / 2

Calculating your average by adding the Inventory over multiple periods (e.g., months) and dividing by the number of periods is possible. For example:

(Month 1 + Month 2 + Month 3) / 3

Example: Alice owns a technology store, and her gaming devices have performed exceptionally well in the last quarter. She wants to know how many gaming devices she had in stock on average in the previous quarter.

She had 10,500 units at the start of the quarter and only 500 at the end. It is how she would calculate it:

Average inventory = (Beginning inventory + Ending inventory) / Months in the period

= (10,500 + 500) / 2 = 5,500

Alice calculates that she had 5,500 units in stock on average during the previous quarter.

Using the following formula, calculate the average for two or more accounting periods. 

Remember that one could extend this formula to cover longer periods, such as dividing the sum of Inventory at the end of every month in a year by 12.

If someone takes an inventory at the start and end of the month, divide it by two to examine a more petite time frame, such as one month.

Average Inventory = (past inventory + present inventory) / # of periods

During October, November, and December, the monetary value of Inventory was $285,000, $313,00, and $112,000, respectively. In the fourth quarter, the total of these three is divided by the number of months.

Example

Oct ending inventory: $285,000

Nov ending inventory: $313,000

Dec ending inventory: $112,000

Total: $710,000

AI = $710,000 / 3 = $236,667 *AI = Average Inventory

The same method calculates the number of units rather than monetary value.

If 30,000 x 45,000 divided by 2 equals 37,500 pallets of flour, the previous month's flour inventory was 30,000 pallets, and the current month's Inventory is 45,000 pallets.

Example

Oct: 30 thousand pallets of flour

Nov: 45 thousand pallets of flour

Overall: 75, thousand pallets of flour

AI = 75 thousand/2 = 37,5 thousand pallets of flour AI* = Average Inventory

What Is Inventory Turnover Ratio?

The inventory turnover ratio measures when someone purchases Inventory and when someone sells the final product to his customers.

It also reveals whether someone is hoarding too much stock. A higher turnover ratio indicates that it is replacing Inventory and moving it. 

However, if someone doesn't keep enough Inventory on hand to meet demand, it can indicate lost sales. To see how someone is doing, compare his company's ratios to those of competitors.

Most firms use automated inventory management solutions to compute the inventory turnover ratio. That software generally includes instructions on how to compute the inventory turnover ratio.

He has two methods if one doesn't want to calculate your inventory turnover ratio by hand.

• First, investigate the inventory management automation system he uses to calculate inventory turnover ratios
• Second, if someone does not already have inventory management software or a B2B eCommerce platform, consider purchasing it

One of the essential Inventory KPIs is the inventory turnover ratio. He must be certain that yours is correct. Computers are excellent at this.

A low inventory turnover rate of less than five is considered poor practice. And that the majority of high-performing organizations keep inventory turnover rates between 5 and 10.

However, as with inventory loss, a "good" inventory turnover percentage varies by industry. ReadyRatios.com data illustrates the average inventory turnover rate across some of the more prominent industries:‍

This is why benchmarking someone's ratio is critical. However, anyone should not subject themselves to an inappropriate benchmark because inventory turnover percentages vary by industry. So everyone should hold themselves to their track record.

Calculating The Inventory Turnover Ratio

Calculate someone's inventory turnover ratio regularly and compare it to previous figures to track their development. Chart progress. Power is what anyone has control over. That's all anyone can have.

Begin by calculating the average Cost of goods sold (COGS), which measures how much it costs to produce the goods, including materials and labor. After that, someone's income statement is where anyone can find it. 

Then use the following formula:

Inventory turnover ratio = Cost of goods sold / average Inventory

The DSI is a metric that determines how long it takes for someone's Inventory to sell. For this formula, someone needs the average once more.

DSI = average inventory / COGS X 365

Lower DSI is usually preferred, but as with the inventory turnover ratio, this varies by industry. To get an idea of performance, compare someone's DSI to that of peer companies.

To learn more examples about inventory turnover. 

Inventory Management Metrics and Analysis

Its results can be used for a variety of accounting and planning purposes. The following are the most common:

1. The average turnover ratio is calculated

The average turnover ratio measures how long someone takes to sell their Inventory after buying it. It is obtained by dividing the total ending inventory by the annual Cost of goods sold to arrive at this figure. 

For example, if someone ending Inventory is $30,000 and his Cost of goods sold is $45,000, his Cost is $45,000. $30,000 divided by $45,000 equals 1.5. It indicates that his Inventory has turned (been sold) one and a half times this year.

2. Calculating the period's average Inventory

By definition, the average must be calculated over at least two periods. Anyone can average two or more months, quarters, or other periods in this way. It is also significant since it demonstrates how inventory turnover varies over time. 

It enables management to better understand its purchasing activities and sales patterns to cut Inventory carrying expenses. It also assists management in determining which goods are selling quickly and which are stagnating. 

It is an essential indicator of a company's ability to turn products into sales.

A decreasing average inventory time often implies that the product is moving faster. In contrast, an increasing inventory suggests that the effects take longer to sell.

The average will reduce the impact of inventory spikes and dips, resulting in a more stable metric to base decisions or compare to other metrics.

3. Sales support calculations

Average helps determine how much Inventory is required to support a given sales level by comparing it to revenues derived from income statements.

These comparisons can be made across two or more accounting periods and year-to-date. When someone compares sales to average figures, anyone can see how many units you sold on average to generate that revenue.

For example, if someone's quarterly sales average $60,000 and his average is 10,000 units, he sold 10,000 units each month during the quarter to generate $60,000 in sales.

Average is a critical component of sales planning because it ensures enough raw materials or finished products are available to meet orders, but not to the point where warehousing and other related costs skyrocket.

However, as the recent pandemic demonstrated, inventory measures and planning must be done regularly to account for changing business, economic, and environmental changes. 

Average is only one tool in the inventory management toolbox.

Challenges in Inventory Management

Some of the challenges are:

1. Seasonal variations cause inaccuracies.

Inventory balances and averages are skewed if a company makes significant sales during a specific season. Inventory balances are typically abnormally high just before a seasonal sales spike and abnormally low afterward.

Seasonal Inventory is merchandise that is in high demand at specific seasons of the year, such as Christmas or Halloween. 

These periods frequently coincide with the changing seasons, and managers must be proactive in preparing for the waxing and fading of demand throughout these critical times.

Christmas, Easter, and Thanksgiving are significant drivers of seasonal inventories in the United States. 

It implies that stores, for example, will notice a spike in demand for specific products during these seasons, including turkey, Christmas decorations, and Easter eggs.

Halloween is another seasonal inventory drive, with merchants frequently expanding the supply of costumes, decorations, and other relevant items.

Similarly, the weeks leading up to the start of school terms are another time of year when demand for certain items increases, and supply often increases in response.

During such periods, shops should expect an increase in school stationery supply and technology such as laptops and software.

2. The quota system

• Inventory balances at the end of the month may reflect a push to meet sales quotas. 
• It can result in month-end inventory levels significantly lower than daily inventory norms.

3. Estimated balances lead to errors.

• The Estimated inventory balances are less accurate than physical inventory counts.
• Inventory mistakes can result in an inaccurate ending inventory balance, which impacts the Cost of products sold and profitability. 
• Given the severe financial effect of inventory errors, it is essential to be aware of the many mistakes that might arise in an inventory system.
• So a clear strategy is the best approach to accomplish a good inventory count. A detailed written policy and instructions reduce unknowns and simplify a physical inventory count.

Moving Average Inventory

• Continuous real-time inventory records are maintained as a result of the perpetual inventory method of accounting.
• Systematized point-of-sale systems and perpetual inventory methods track sales and inventory depletion or restocking, allowing them to reflect inventory changes immediately.
• When comparing inventory averages over time, companies can use a moving average method that uses the perpetual inventory method.
• To convert pricing to the current market standard, the moving average allows for a more accurate comparison of periods.

The average cost is recalculated after each purchase with the moving average method inventory. Thus, inventory costs will fall between the FIFO and LIFO methods.

It is a conservative middle ground as one of the safest and most reliable methods for averaging inventory costs—the moving average price of inventory changes with each purchase.

In this way, perpetual inventories are used by businesses to manage inventory. The list is only calculated in a periodic inventory system at the end of accounting periods.

The moving average won't be accurate if inventory costs aren't updated in real-time with each purchase.

It's also challenging to keep up with the moving average method inventory because costing with inventory management programs often automatically adjusts to a moving average. 

Calculating Moving Average Inventory

Calculating a moving average without the help of software is a grim prospect.

It is a method for inventory valuation or delivery cost calculation in which the unit cost is calculated each time inventory goods are accepted rather than calculating the price at the end of the month or accounting period, like this example. 

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Another Example:

• On April 1ABC company had 1000 green widgets in stock for $5 per unit. 
• The initial inventory = $5000
• ABC company bought 250 more for 6$ on April 10 for a total of $1,500).
• On April, 20the company bought 750 per 7$ (for a total of $5,250).
• The moving average cost per unit at the end of April would be $5.88.
• Total Cost = 5,000+1,500+5,250
• Total Cost = 11,750$
• The moving average cost = 11,750 ÷ 2000 = $5.875 at the end of the month

*2000 =  (1,000 beginning balance + 250 units purchased + 750 units purchased)

Researched and authored by Fatemah Kamali | LinkedIn

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