Average Inventory Overview
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.
Average Inventory Calculation
In the first case, where 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
In the second case, where 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|
|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
Average Inventory Problems
The following are all problems with the average inventory calculation:
Month-end basis. The calculation is based on the month-end inventory balance, which may not be representative of the average inventory balance on a daily basis. For example, a company may traditionally have a huge sales push at the end of each month in order to meet its sales forecasts, which may artificially drop month-end inventory levels to well below their usual daily amounts.
Seasonal sales. If you are using an inventory average that is based on the month-end balances for the year-to-date, results can be skewed if the company’s sales are seasonal. This can cause abnormally low inventory balances at the end of the main selling season, as well as a major ramp-up in inventory balances just before the start of the main selling season.
Estimated balance. 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.