Average Inventory Defined: Formula, Use, &

Challenges
Abby Jenkins | Product Marketing Manager

January 13, 2021

Inventory management is key to managing costs and maintaining customer satisfaction. Too
much inventory on hand means capital is tied up unnecessarily and may even be at risk. For
example, some perishable, trendy or seasonal items may not last for long. Too little inventory on
hand can lead to missed sales opportunities and empty store shelves. Just the right amount of
inventory propels a company forward and mirrors its strengths in managing costs, sales and
business relationships.

Calculating average inventory is a useful accounting measure to track changes and activities over
time. This is often a better lens to view a company’s inventory standing than a single point in
time or accounting period.

What Is Average Inventory?

Average inventory is an estimation of the amount or value of inventory a company has over a
specific amount of time. Inventory balances at the end of each month can fluctuate widely
depending on when large shipments are received and when there’s a buying surge or peak season
that may markedly deplete the inventory. An average inventory calculation evens out such
sudden spikes in either direction and delivers a more stable indicator of inventory readiness.

What Is Inventory? Inventory can be raw materials or finished products, and the term refers to
the number of goods on hand ready for sale or the amount of raw material on hand to produce
salable goods.

Key Takeaways
  Average inventory is the average amount or value of your inventory over two or more
accounting periods.
 It is the mean value of inventory over a given amount of time. That value may or may not equal
the median value derived from the same data.
 Average inventory can be used for meaningful comparisons to other data points. For example, in
tracking inventory losses due to shrinkage, damage and theft by comparing average inventory to
overall sales volume in the same period.

Average Inventory Explained

Average inventory is a calculation of inventory items averaged over two or more accounting
periods. To calculate the average inventory over a year, add the inventory counts at the end of
each month and then divide that by the number of months. Remember to also include the base
month in fiscal year average inventory calculations which also means you would divide that sum
by 13 months rather than 12. Average inventory figures for other stretches of time are similarly
calculated.

Here’s one way to use average inventory for a comparison. Take the revenue from your last
fiscal year and compare it to your average inventory from the same time. This will show you
how much inventory each month on average you needed to supply and support that amount of
sales. You could perform the same exercise for any given period—year-to-date, a quarter or even
a month.

Importance of Average Inventory

Your inventory will fluctuate. You might get a massive delivery at the end of the month. Or you
might be stocking up for a specific sale. Or maybe your business is seasonal—like ice cream in
the summer or holiday decorations in winter. Looking at a single point in time won’t necessarily
give you an accurate picture of your inventory.

When negotiating with suppliers and making strategic decisions about how much stock to order,
you need to have a good grasp on the big picture. How much inventory will you need to support
the sales to fund the bottom line? The average inventory can help by giving you the overview for
a given period.

The average inventory is also a key component of understanding how quickly you’re able to turn
inventory into sales. This is done with the inventory turnover ratio and the days sales of
inventory (DSI).

Your Complete Guide to Inventory Forecasting

Effective inventory forecasting can mean the difference between profitability and piles of unsold goods
that eat up your available cash. The bottom-line impact of inventory forecasting is clear: less money is
tied up in inventory, stock is maintained at a realistic threshold and ordering becomes much more
precise.

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What Is Inventory Turnover Ratio?
The inventory turnover ratio is a way to look at how much time passes between when you buy
inventory and when the final product is sold to your customers. It also shows if you’re holding
onto too much stock. A higher turnover ratio means you’re replacing your inventory and moving
product. But it can also be an indicator of lost sales if you’re not holding onto enough inventory
to meet demand. Benchmark your business against peer company ratios to see how you’re
performing.

To calculate the inventory turnover ratio, start by finding the average inventory and the cost of
goods sold (COGS), which is a measure of how much it takes to produce your goods including
materials and labor. It is usually listed on your income statement. Then follow this formula:

Inventory turnover ratio = Cost of goods sold / average inventory

The DSI is a measure of how many days it takes for your inventory to be sold. You’ll need the
average inventory again for this formula.

DSI = average inventory / COGS X 365

Lower DSI is usually desirable, but like inventory turnover ratio this will vary by industry.
Benchmark your DSI against peer companies to get idea of performance.

Average Inventory Formula and Calculations

Determine average inventory for two or more accounting time periods using the following
formula. Keep in mind, you could extend this formula to cover extended periods of time, like
adding up the inventory at the end of each month in a year and dividing by 12. You can also look
at smaller timeframes, like looking at a single month by taking the inventory at the beginning of
a month and end of a month and dividing by 2.

Average Inventory = (current inventory + previous inventory) / number of periods

Average Inventory Examples

For example, if the monetary value of inventory at the close of October, November and
December is $285,000, $313,00 and $112,000, the average inventory for the fourth quarter
would be the sum of all three divided by the number of months.

October ending inventory: $285,000

November ending inventory: $313,000

December ending inventory: $112,000

Total: $710,000

Average inventory = $710,000 / 3 = $236,667

Calculating average inventory in terms of number of units instead of monetary value is done the
same way. If a bakery’s previous month’s inventory balance is 30,000 pallets of flour and the
current inventory balance is 45,000 pallets, then the average inventory for the two months is
30,000 plus 45,000 divided by 2—or 37,500 pallets of flour.

October: 30,000 pallets of flour

November: 45,000 pallets of flour

Total: 75,000 pallets of flour

Average inventory = 75,000/2 = 37,500 pallets of flour

Moving Average Inventory

Companies using the perpetual inventory method in accounting have a continuous real-time
record of inventory. Computerized point-of-sale systems and inventory management software
immediately reflect changes in inventory by tracking sales and inventory depletion or restocking.

Companies that use the perpetual inventory method can use a moving average inventory to
compare inventory averages across multiple time periods. Moving average inventory converts
pricing to the current market standard to enable a more accurate comparison of the periods.

3 Problems, Drawbacks and Challenges with Average

Inventory
While average inventory is useful in inventory management, it does have a few drawbacks:
 1. Inaccuracies due to seasonal cycles. If a company makes a large portion of its sales in a specific
season it skews inventory balances and the average inventory. Typically, inventory balances are
abnormally high just prior to a seasonal sales spike and abnormally low afterwards.
2. The quota factor. Month end inventory balances may reflect a push to meet sales quotas. This
can lead to an artificial drop in month-end inventory levels that are far below the daily inventory
norms.
3. Estimated balances lead to errors. Using estimated inventory balances isn’t as accurate as using
physical counts of inventory.

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3 Ways to Use Average Inventory Results

Average inventory results are useful for a variety of meaningful accounting and planning tasks.
Here are the most common:

1. Calculating average turnover ratio. The average turnover ratio is a measure of the amount of
time it took to sell inventory after you purchased it. To calculate it, divide the total ending
inventory into the annual cost of goods sold. For example: your ending inventory is $30,000 and
your cost of goods sold is $45,000. Divide $45,000 by $30,000 which equals 1.5. This means your
inventory has turned (been sold) one- and one-half times during the year.
2. Calculating average inventory for the period. Average inventory by definition must be
calculated over at least two periods. That means you can average two or more months, quarters
or other time periods. Average inventory will lessen the impact of spikes and dips in inventory to
render a more stable measure to base decisions upon or to compare to other metrics.
3. Sales support calculations. Average inventory is useful for comparison to revenues derived from
income statements to determine how much inventory is needed to support a given sales level.
These comparisons can be done over two or more accounting periods, and even as year-to-date
comparisons. Matching sales against average inventory figures reveals the average number of
units you sold to generate that amount of sales revenue.

For example, if the average for your quarterly sales is $60,000 and the average inventory is
10,000 units, then you sold an average of 10,000 units each month in the quarter to generate
$60,000 in sales for the period.

Average inventory is an important element in sales planning to ensure enough raw materials or
finished products are available to meet orders, but not so much as to drive up warehousing and
other related costs.

But both inventory measures and inventory planning must be done regularly to take into account
changing business, economic and environmental changes as was recently demonstrated in the
latest pandemic. Average inventory is just one tool in the toolbox of inventory management.