Anyone who’s ever purchased wholesale from suppliers or vendors knows: price change is a constant. And that makes inventory costing and calculating the cost of goods sold (COGS) difficult.
But average inventory smooths it out. Literally. Average inventory employs an 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 so helpful, and how to calculate it.
What Is Average Inventory?
Average inventory is the mean value of a company’s inventory over a specific period of time. 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 average inventory on hand.
Average inventory is useful for both inventory management and accounting. From a management perspective, it’s typically used to calculate inventory turnover ratio and days sales in inventory. That’s how many times inventory is sold and replenished over a set period of time. Inventory turnover is a fundamental metric when evaluating overall inventory management efficiency. And average inventory on hand is needed to calculate it.
The mean value of average inventory can apply to two things, though: inventory cost or inventory level.
Average Inventory Cost
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 you’d calculate the average using monetary value.
That’s as opposed to average inventory level, which doesn’t involve costing.
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 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 inventory and LIFO inventory costing methods. It’s a risk-averse middle ground that’s 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. If the cost of your inventory isn’t being updated in real time, with each purchase, you won’t have an accurate moving average.
It’s also difficult to keep up with moving average method inventory because costing with inventory management programs often automatically adjust to a moving average. Calculating a moving average on your lonesome—without the help of software—is a grim prospect indeed.
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.
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 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 Average Inventory on 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 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 costs and declining sell through rates, among other things.
But, again, this is only possible with inventory management software. Automated calculation and perpetual inventory are necessary.