Anyone who’s ever placed a purchase on an online marketplace from suppliers or vendors knows: price change is a constant. And that makes inventory costing and calculating the cost of goods sold (COGS) difficult (see inventory meaning). This is why it's important to know how to calculate finished goods inventory.
But average inventory smooths it out. Average inventory employs an eCommerce accounting strategy called smoothing that levels out value fluctuations.
By providing accurate and consistent numbers over long periods of time, average inventory helps in many ways. Balance sheets are cleaner. Inventory turnover ratio is clearer. Inventory management is easier. And that means more revenue.
Let’s take a look at average inventory, why it’s a helpful inventory KPI, and how to calculate it.
What Is Average Inventory?
Average inventory is the mean value of a company’s inventory over a specific period. Like any other average, it’s calculated by adding two values and dividing by two. In this case, the beginning inventory is added to the ending inventory of a time period. Divide the sum by two to determine the average inventory on hand.
Average inventory is helpful for both inventory management and eCommerce accounting. From a restaurant management perspective, it’s typically used to calculate inventory turnover ratio and inventory days.
That’s how often inventory is sold and replenished over a set period of time. The inventory turnover formula is used as a fundamental metric when evaluating overall multichannel inventory management efficiency. An average inventory on hand is needed to calculate it.
The mean value of average inventory can apply to two things: inventory cost or inventory level. Be mindful of the FIFO method when calculating inventory costs.
What is Average Inventory Cost
The average inventory cost is the cost of goods available for sale divided by the number of inventory units on hand. You can use the average inventory cost to compare the cost of goods available for sale at different times or different locations.
Companies calculate average inventory by assigning a dollar value to the inventory it averages. To determine average inventory cost, you’d determine the cost per unit with an inventory costing method.
You’d apply that cost to your beginning and ending inventories, and calculate the average using monetary value. That’s as opposed to the average inventory level, which doesn’t involve costing.
Want to develop a strategy to cut inventory expenses? Learn more about SKU rationalization and how it can streamline supply chain management operations.
What is Average Inventory Level
The average inventory level refers to the number of units, not the monetary value of those units. Determining average inventory level is easier than determining the average inventory cost. There’s one less calculation: you do the same thing, but assign no cost to products. You’re just averaging their quantity.
What Is the Moving Average Inventory Method?
Moving average method inventory recalculates average inventory cost after every inventory purchase. This yields an inventory cost that’s between FIFO and LIFO inventory costing methods. A risk-averse middle ground is one of the safest and most stable ways of averaging inventory cost.
The moving average cost of inventory changes with each new purchase. That’s why companies use this inventory method with perpetual inventory. A periodic inventory system only calculates inventory at the end of accounting periods. With each purchase, you won’t have an accurate moving average if the cost of your inventory isn’t being updated in real-time.
It’s also difficult to keep up with the moving average method inventory because costing with inventory management programs often automatically adjusts to a moving average. Calculating a moving average on your lonesome—without the help of software—is a grim prospect.
How to Calculate Average Inventory
Earlier we stated that to calculate average inventory, you need only divide the sum of beginning and ending inventory by two. By and large, that’s true. But there’s another way to calculate average inventory. And that’s average inventory per time period. Per month or per week, for example.
Average Inventory Formula
Here’s the average inventory formula for calculating average inventory on hand across a set time period:
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
And here’s the average inventory formula for calculating average inventory per time period across a larger time period:
Average Inventory = (Beginning Inventory + Ending Inventory) / Number of Time Periods
Let’s look at two examples to see how this all works.
How to Find Average Inventory
Consider BlueCart Coffee Company, a fictitious company. They purchase unroasted green coffee beans, roast them, package them, and sell them. This is the ideal process for coffee marketing.
We’ll be finding average inventory for over a 12-month time period. To do that, we’ll need beginning inventory and ending inventory.
How to Calculate Beginning Inventory
For starters, beginning inventory is the previous accounting period’s ending inventory. If you have that, you don’t need to calculate the beginning inventory.
But if you don’t have beginning inventory recorded, you can retroactively calculate it with this beginning inventory formula:
Beginning Inventory = (Ending Inventory + COGS) - Inventory Purchased
Just consult your accounting records for your COGS (which includes inventory shrinkage), ending inventory, and any inventory purchased over the time period evaluated.
For our example, let’s say ending inventory is $5,000, COGS is $4,000, and purchased inventory is $2,000.
Beginning Inventory = (Ending Inventory + COGS) - Inventory Purchased
Beginning Inventory = ($5,000 + $4,000) - $2,000
Beginning Inventory = $7,000
How to Calculate Ending Inventory
You can calculate ending inventory with this ending inventory formula:
Ending Inventory = Beginning Inventory + Purchased Inventory - COGS
Finding Average Inventory
The average inventory for BlueCart Coffee Company over the year is:
Average Inventory = ($7,000 + $5,000) / 2
Average Inventory = $6,000
BlueCart Coffee Company had an average of $6,000 worth of coffee inventory on hand throughout the year.
If you were to consider only the quantity of units and not their price, that’s how to calculate average inventory level).
Average Inventory Accounting
That’s how to calculate average inventory. Great! But how does average inventory accounting work? Where does it show up on the ledger?
What Is the Average Inventory on a Balance Sheet?
In general, inventory is reported on the balance sheet as a current asset, which is expected to be converted to cash within a year. When inventory is sold, that cost is reported under the COGS on the balance sheet. And when that cost is a moving target, average inventory cost is helpful.
Average inventory isn’t always reported on balance sheets. It’s mostly used to calculate inventory turnover. And to generally contrast against demand planning, inventory forecasting, sales strategy, and purchasing habits.
Average Inventory, Smooth Inventory
Smoothing inventory costs with average inventory is how companies make strategic decisions without the noise of large cost fluctuations and outliers.
By considering the most consistent inventory numbers possible, businesses minimize risk in purchasing and sales strategies. Risks that can lead to bloated inventory carrying cost and declining sell through rate, among other things.
But, again, this is only possible with restaurant inventory software. Automated calculation and perpetual inventory are necessary and conserve resources when it comes to performing a regular inventory audit in your warehousing environment.
Drawbacks and Challenges With Average Inventory
There are several potential drawbacks and challenges that come with using average inventory methods:
- One such challenge is the inaccuracies that can occur due to seasonal cycles. For example, suppose a company sells more of its product in summer than in winter. In that case, its average inventory will be artificially low during the winter and artificially high during the summer. Similarly, if a company's sales fluctuate significantly from month to month, this can lead to inaccuracies.
- Another challenge is the quota factor. One-time events or fluctuations can skew average inventory levels. For example, if a company has a big sale at the end of the month, its average inventory levels for that month will be lower than usual. This can make it challenging to gauge proper inventory levels and trends accurately.
- Finally, estimated balances can also lead to errors in the average inventory calculation. This is because inventory levels can change rapidly and unexpectedly, making it challenging to predict average inventory levels accurately. This can lead to planning and decision-making errors, as well as issues with customer satisfaction if they do not receive the products they ordered when they expect to.
What’s the Meaning of the Average Inventory Formula
The average inventory formula can help a business in various ways. It can help assess turnover rates, liquidity, and inventory management efficiency. Here are the main applications of the average inventory formula.
- Financial analysis. Inventory is a major financial asset in multiple industries. For example, inventory is often the biggest asset of distributors and wholesalers. Therefore, using the average inventory formula to calculate this ratio can be an important tool in their financial analysis.
- Inventory management efficiency. Whether a business is preparing for its peak season or wishes to tackle inventory inefficiencies, the average inventory formula can be of help.
- Calculating performance. Metrics such as the cost of goods sold or inventory turnover ratio can be used to in addition to average inventory. That way a business can have additional insights into their performance, liquidity, and inventory management.
- Pricing strategy. The average inventory formula can be used to help determine the pricing strategy. High average inventory can be the reason for lacking sales and too high prices. On the other hand, low average inventory might mean that the pricing needs to be updated and increased.
Frequently Asked Questions About Average Inventory Formula
If successful inventory management can be boiled down to one thing, it would be the right formulas. Calculating the average inventory formula is the start of proper restaurant inventory management. The inventory management process can be difficult, but with the proper average inventory formula, it's quite simple, especially with restaurant inventory software. Now that you've learned the basics, continue reading these commonly asked questions and answers:
How Do You Calculate Ending Inventory Using FIFO?
Calculating ending inventory with FIFO (first in, first out) is pretty straightforward. First, you take the number of units you sold within a 30-day period. Second, multiply that number by the per-unit cost of your most recent inventory. This gives you your ending inventory amount for the month.
Here’s what an example of the formula looks like:
3,265 products sold x $6.85 unit price = $22,365.25 ending inventory with FIFO
This inventory calculation method can be useful if your unit price often fluctuates, or the price rose significantly after having remained stagnant for a while.
What Are the 4 Inventory Costing Methods?
The four main inventory costing methods are as follows:
- First in, first out. This method uses the inventory that was purchased first when calculating what was sold in a given period.
- Last in, first out. This method uses the inventory that was purchased most recently when calculating what was sold in a given period.
- Weighted average. The weighted average costing method applies the same unit cost to similar units. This is easiest done when product units are so similar that applying the same price is expedient and simpler.
- Specific identification. With this method, you identify specific items that were purchased but have not been sold, and determine inventory costs that way. Specific identification is a method that works well for relatively unique products, like cars and homes.
What Is the Average Cost Method for Inventory?
The inventory average cost method takes the total cost of goods purchased or manufactured and divides it by the total number of items purchased or manufactured. This is also called the weighted-average method.
Here is an example of the average cost method:
$16,000 total purchased / 2,500 total items = $6.40 average unit or product cost.
This average costing method is most relevant when a business, including an eCommerce business, sells only a few types of products (or just one). The greater material, value, or price variance there is between products, the less accurate average costing is.