Average Inventory

Average inventory is the typical amount of inventory a business holds over a period, measured in dollars or units. It is most often calculated as the average of the beginning and ending inventory balances for the period, though monthly or even weekly averages are more accurate when available. Its main use is as the denominator of the inventory turnover ratio and related measures of how quickly stock is sold.

Average inventory should not be confused with the average cost of inventory, which is a cost flow method for valuing units, also called weighted-average cost. Average inventory is a level of stock over time; average cost is a price per unit. A company using FIFO, LIFO or average cost can calculate average inventory in exactly the same way.

A bookshop's shelves are fuller some weeks than others. Just after a delivery, it may hold $60,000 of books; just before the next one, perhaps $20,000. If the owner asks how much money is usually sitting on the shelves, the answer is a middle figure, the average across the year.

Comparing that average with how much the shop sells shows how many times the stock is replaced in a year. Fast-moving stock means less cash tied up and less risk of books going out of date.

The basic calculation is:

A hardware retailer starts the year with inventory at cost of $250,000 and ends with $310,000. Average inventory is ($250,000 + $310,000) ÷ 2 = $280,000. With cost of goods sold of $1,680,000, inventory turnover is $1,680,000 ÷ $280,000 = 6 times a year. Days' sales in inventory is 365 ÷ 6, or about 61 days, meaning a typical item sits on the shelf for about two months before it is sold.

Turnover should be calculated with cost of goods sold rather than sales, since inventory is carried at cost. Dividing sales by average inventory mixes a selling-price figure with a cost figure and overstates turnover.

Many businesses choose a fiscal year that ends when inventory is at its lowest, for example a retailer closing its year after the holiday season. In that case, both the opening and closing balances are unusually low, and the two-point average understates the inventory carried during most of the year. Adding up the 13 month-end balances, from the opening balance through the last month, and dividing by 13 produces a more representative figure. A company using a perpetual inventory system can produce such averages easily from its records; one using a periodic inventory system may have only the year-end physical count to work with.

• Turnover and holding period. Average inventory drives inventory turnover and days inventory outstanding, both measures of how efficiently stock is managed.
• Carrying cost. Storage, insurance, financing and obsolescence costs depend on how much stock is held, so the carrying cost of inventory is often estimated as a percentage of average inventory.
• Ordering policy. In the economic order quantity model, average inventory equals half the order quantity plus any safety stock, linking ordering decisions to holding costs.
• Cash flow. Higher average inventory relative to sales ties up more working capital and lengthens the cash conversion cycle.

Average inventory is only as comparable as the valuation behind it. Under LIFO, older, lower costs may stay in inventory for decades, so average inventory looks small and turnover looks high compared with a company using FIFO. Write-downs to the lower of cost and net realizable value, which applies to FIFO and average-cost inventory under current US GAAP, also reduce inventory balances. Acquisitions, store openings and sudden supply disruptions can distort averages within a year. Analysts therefore compare turnover with past periods and close competitors, read the inventory note for the cost method used, and treat a single year's ratio as a starting point for questions rather than a final judgment.