If you run a business, the chances you heard the term “Average Inventory” thrown around is very high. Although the name Average inventory, transmits the meaning of the term pretty clearly, there is a still a formula behind the term. In this article, we are going to talk about what is average inventory, the significance of the term and how to implement it in your business to get the best out of something as simple as average inventory.
What Is Average Inventory?
Average inventory is a fast way to get a hold of a company’s inventory during a certain time period. The average Inventory formula is relatively simple. First, you get the beginning inventory of your business and sum it up with the ending inventory. Then you need to divide the summed-up number by the number of months you took in the accounting period.
How to Calculate Average Inventory
(Beginning Inventory + Ending Inventory) / Number of Months
Let’s show it in a simple example to understand Average Inventory better:
Imagine you have $1000 worth of inventory in January and $1200 worth of inventory in February. After you sum up these numbers, you get $2200. Now you can divide it by the number of months, in this case, 2, to get your average inventory.
(1000+1200) / 2 = 1100
So, your imaginary company’s average inventory costs $1100.
Now that you learned how to get the average inventory for your business, it is time to talk about the benefits of knowing your business’ average inventory.
Average Inventory is mostly utilized in terms of the accounting aspects of your business. It helps to reach accurate balance sheets and income statements.
Another way to utilize the average inventory is when calculating the inventory turnover. Let’s explain inventory turnover quickly to get a grasp of the situation.
What is Inventory Turnover?
In the simplest terms, inventory turnover helps you measure the financial state and performance of your business. Generally, higher inventory turnover means your business is in better shape. As the inventory turnover rates drop, the inefficiency of your company rises.
To understand it better, we can take a look at the inventory turnover formula. This formula includes average inventory and helps you learn about the sales performance of your company.
Let’s take a look at the inventory turnover’s formula:
Cost of sold goods / Average Inventory
The inventory Turnover formula utilizes the Average Inventory instead of ending inventory. The reasoning behind that is because a company’s sales and inventory change so much in a year. It is better to calculate your inventory ratio with average inventory for more accurate results throughout the year.
Inventory Turnover basically lays out your yearly plan for the inventory. You cannot let it drop to a certain number because when you do, you get extra inventory, which is often a bad sign for a business. Extra inventory caused by low inventory turnover produces extra costs such as storage and maintenance costs of those extra products.
Inventory Turnover ratio is very crucial for businesses. Although it seems like a relatively simple equation, inventory turnover needs proper communication between sales and purchasing departments. If companies cannot keep the inventory turnover at the desired rate, it may cause huge problems going forward.
Average Inventory Problems
It is never easy to run a company without a plan. Thankfully, there are some shortcuts you can take to make this process more bearable. Average Inventory is one of those shortcuts. It has apparent benefits for your business such as laying out a proper yearly accounting plan for a company. However, relying on those short cuts too much might be problematic in the long run. In the case of the Average Inventory, the problems stem from its inaccuracy in the short and long runs.
The problems with the average inventory in the short run are created by the difference between monthly and daily numbers. It is easy and mostly accurate to just utilize average inventory for a yearly accounting plan. However, when it comes to inspecting a specific month of sales, there are many different variables we do not consider with an average inventory. One of those is the variance in salesmen’s performance during different weeks of the month. Salesmen in business generally work harder and go for bigger sales in specific weeks which they get a bonus for every sale they made. A huge variable like this is not accounted for in the Average Inventory. This can lead to wrong numbers and many more problems for the company.
Some companies use the estimated inventory to not lose any days with a manual inventory check. This is another case where average inventory falls short. Because those companies have an estimated number for their inventory, average inventory just fails because of the inaccuracy.
Even though the Average Inventory has its possible downsides, it is still a practical formula for your business. It is a very useful shortcut that can save you huge amounts of time. The trick is not relying on the Average Inventory in every aspect of your business.