When managing inventory, whether shipments are being received or orders are being shipped out, the flow of goods rarely happens at a consistent pace. For that reason, assessing inventory levels at a single point in time may not yield insights that are indicative of a company’s true inventory status. By determining average inventory calculations over a longer period of time, it is possible to attain a more reliable view of a company’s inventory readiness.
What is average inventory?
Average inventory is a metric for determining the number of units of inventory a company holds over a specific accounting period. This includes both goods ready for sale and the raw materials needed to make these goods. Rather than relying on a view of current inventory balances determined at the end of the month, for example, average inventory takes a broader view of inventory trends. In this manner, it's possible to counteract the effects of short-term fluctuations of inventory moving in or out of the warehouse.
Average inventory formula calculations: Find your Average Inventory
Below are three simple formulas to help you get an accurate view of average inventory and its associated metrics.
Average inventory formula
To determine average inventory, just add the inventory at the beginning of the period to the inventory at the end of the period and divide by two.
Average inventory = (beginning inventory + ending inventory) / 2
Average inventory formula example
If beginning inventory is 70,000 and ending inventory is 30,000, the average inventory is 50,000.
Inventory turnover ratio formula
Calculating inventory turnover ratio is achieved by dividing cost of goods sold (COGS) by average inventory.
Inventory turnover ratio= (COGS/average Inventory)
Inventory turnover ratio example
If COGS is $200,000 and we apply the above average inventory calculation of $50,000, the inventory turnover ratio is 4.
Average inventory period formula
Finally, to determine the average inventory period, divide the number of days in the period by the inventory turnover ratio.
Average inventory period = (number of days in period/inventory turnover ratio)
Average inventory period formula example
Above, we determined that our inventory turnover ratio in this hypothetical example is 4. So, if a company wished to calculate its average inventory period over a 90-day period of time, the resulting calculation would be 22.5.
Why knowing the average inventory is important for your business
Knowing the average inventory of your business can help provide a bird’s eye view of performance, sales, and efficiency. This is especially true for companies that are highly affected by seasonal shifts in demand, such as landscapers, ice cream shops, and food trucks. For these businesses, the average inventory is a more accurate description of overall inventory and profitability than any point-in-time inventory count for a given period.
5 benefits of maintaining a view of average inventory levels
1. Simplify the process of knowing how much inventory is needed to support sales efforts. Average inventory can be used to determine how much inventory is needed to meet particular sales figures or to make year-over-year comparisons.
For example, your accounting team can compare YTD average inventory to YTD revenue to calculate the amount of inventory—and its associated cost burden—needed to meet sales figures and net profit objectives.
2. Optimize cost of inventory by avoiding carrying too much of items with low inventory turnover rates. By calculating inventory turnover ratio using average inventory for particular SKUs, you can determine your most profitable products as well as the items that are wasting valuable warehouse space.
To accomplish this, compare your data to your industry peers to identify outliers. A very high inventory turnover ratio may suggest that your prices are too low, while a very low inventory turnover ratio could indicate a product that is out of season or no longer in fashion.
3. Increase customer satisfaction by maintaining sufficient levels of in-demand items that demonstrate high inventory turnover rates.
For example, the owner of a retail ice cream shop may use inventory turnover to determine which flavors are most popular with customers. Later, the owner can use this information to make sure there is sufficient inventory on hand to avoid stockouts during a customer acquisition event (such as catering a music festival).
4. Manage the bottom line more effectively by more accurately forecasting cash flow and overall sales volume. This can help provide peace of mind and stability for businesses that must deal with severe fluctuations in sales figures and inventory needs.
For example, average inventory can reduce your company’s likelihood to overestimate or underestimate inventory on-hand due to checks performed following a large shipment of inventory in or out of your warehouse.
5. Identify and address shrinkage issues. By performing more frequent inventory checks and automating the calculation of average inventory, your business will be better equipped to discover discrepancies in the inventory list and actual inventory on hand. Specifically, this can help identify fraud, theft, damage, or accounting errors more quickly and efficiently than waiting for monthly, quarterly, or annual inventory checks.
When to use average inventory calculations
Calculating average inventory has some specific use cases, which we will discuss in detail below. Here are five ways business owners can take advantage of the average inventory calculation to drive profitability and efficiency.
- Calculating inventory turnover ratio.
- Calculating average inventory period.
- Seeking to minimize inventory shrinkage.
- Determining inventory requirements to meet particular revenue goals.
- Comparing quarterly performance figures.
Average inventory and shrinkage
Perhaps one of the less obvious benefits of average inventory is its ability to help companies deal with shrinkage, which is simply defined as the difference between recorded inventory and physical inventory. These discrepancies can be caused by numerous issues including internal or external theft, damage, bookkeeping mistakes, or vendor fraud.
In addition to the obvious issue of lost profits, shrinkage creates inventory headaches if it is not detected and a company believes it has more sellable inventory than is actually on hand.
Average inventory figures provide a helpful point of comparison for companies seeking to identify shrinkage. By comparing average inventory to actual sales volume, it can be possible to track inventory losses that may have occurred due to shrinkage as well as related issues such as perishable inventory that has expired.
Common issues with average inventory
While average inventory can be a useful tool, it's by no means a silver bullet for meeting all your inventory management needs. Potential drawbacks to consider include:
- It’s determined based on the ending inventory balance of the period, which may or may not reflect the true average.
- It's typically based on an estimated amount of inventory which is, by nature, less precise than physical inventory counts.
- It can create issues for seasonal business. If a business distributes surfboards, for example, it's reasonable to assume that a high percentage of its sales will occur during the summer months. If that business were to rely solely on average inventory for its inventory planning, seasonal spikes would be harder to spot, resulting in too little inventory when it's needed most and too much inventory the rest of the year.
Key takeaways
Effective inventory management can have a tremendous impact on a company’s balance sheet. Monitoring average inventory can help you see past short-term inventory fluctuations to maintain a more reliable view of inventory levels, reliably deliver the goods your customers are demanding, and forecast your future needs with greater accuracy. However, it's not a perfect solution and its potential drawbacks must be evaluated against the needs of each specific business.
QuickBooks can help
To learn how inventory management software like QuickBooks Online Advanced can help streamline inventory management for your growing business, visit QuickBooks today.
