Average inventory calculation
/What is Average Inventory?
Average inventory is the mean value of inventory on hand over a measurement period. It can be useful for budgeting purposes, to estimate the amount of working capital investment that a business will need over an extended period of time.
Average inventory is used to estimate the amount of inventory that a business typically has on hand over a longer time period than just the last month. Since the inventory balance is calculated as of the end of the last business day of a month, it may vary considerably from the average amount over a longer time period, depending upon whether there was a sudden draw-down of inventory or perhaps a large supplier delivery at the end of the month.
Average inventory is also useful for comparison to revenues. Since revenues are typically presented in the income statement not only for the most recent month, but also for the year-to-date, it is useful to also calculate the average inventory for the year-to-date and then match the average inventory balance to year-to-date revenues, to see how much inventory investment was needed to support a given level of sales.
How to Calculate Average Inventory
When you are simply trying to avoid using a sudden spike or drop in the month-end inventory number, the average inventory calculation is to add together the beginning inventory and ending inventory balances for a single month, and divide by two. The formula is:
(Beginning inventory + Ending inventory) ÷ 2 = Average inventory
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When you want to obtain an average inventory figure that is representative of the period covered by year-to-date sales, add together the ending inventory balances for all of the months included in the year-to-date, and divide by the number of months in the year-to-date. For example, if it is now March 31 and you want to determine the average inventory to match against sales for the January through March period, then the calculation could be:
| January ending inventory | $185,000 |
| February ending inventory | $213,000 |
| March ending inventory | $142,000 |
| Total | $540,000 |
| Average inventory = Total / 3 | $180,000 |
Days of Inventory
A variation on the average inventory concept is to calculate the exact number of days of inventory on hand, based on the amount of time it has historically taken to sell the inventory. This calculation is:
365 ÷ (Annualized cost of goods sold ÷ Inventory)
Thus, if a company has annualized cost of goods sold of $1,000,000 and an ending inventory balance of $200,000, its days of inventory on hand is calculated as:
365 ÷ ($1,000,000 ÷ $200,000) = 73 Days of inventory
Problems with Average Inventory
While it provides a quick approximation for financial and operational analyses, the average inventory concept has several drawbacks. These issues are as follows:
Oversimplification. This method assumes inventory usage and replenishment are consistent throughout the period, which rarely reflects actual fluctuations. It fails to capture the dynamic nature of inventory changes caused by seasonality, promotions, or supply chain disruptions.
Could be based on an estimate. Sometimes the month-end inventory balance is estimated, rather than being based on a physical inventory count. This means that a portion of the averaging calculation may itself be based on an estimate, which in turn makes the average inventory amount less valid.
Inaccuracy in high-variation scenarios. For businesses with high variability in demand or supply, average inventory can misrepresent actual stock levels.
Masks stockouts and overstocking. Average inventory might hide instances of stockouts or overstocking, giving a false sense of stability in inventory management.
Does not reflect actual holding costs. Inventory holding costs are influenced by daily or weekly stock levels, not averages over a long period. Using average inventory could misrepresent actual carrying costs.
Difficulty in tracking trends. Relying on an average obscures trends in inventory usage or replenishment, making it harder to identify areas for improvement or inefficiencies.
Potential for misleading metrics. Metrics such as inventory turnover ratio or days of inventory on hand derived from average inventory may not accurately represent operational efficiency.
In summary, while the average inventory concept can simplify calculations, its inherent assumptions and limitations make it unsuitable for precise decision-making in complex or dynamic inventory systems.
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