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The average inventory value is the mean inventory value over a specific time period, which may differ from the median value for the same data set. It is calculated by averaging the beginning and ending inventory numbers across an interval, such as a month, a quarter, or a year.Â
A company's average inventory for the year is ($100,000 + $120,000) / 2 = $110,000, for instance, if it starts the year with $100,000 in inventory and ends it with $120,000.
Additionally, average inventory can be determined by using more than two data points throughout the course of a period. For instance, a corporation can utilize the inventory numbers at the end of each month for a given quarter to determine its average inventory for that quarter. This can assist in reducing any peaks or outliers that may happen within a single month. 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:
Average Inventory = ($285,000 + $313,000 + $112,000) / 3 = $236,667
The average inventory can be described in terms of value or units. The former relates to the total number of things in stock, whilst the latter refers to their market value. Either one may be employed, depending on the goal of the analysis. Utilizing value, however, might be more precise and reliable because it takes into account how prices and discounts vary over time.
Why Is Average Inventory Useful?
There are various benefits to having an average inventory. First, it aids firms in measuring the effectiveness and performance of their inventory. Businesses can compute important ratios like inventory turnover and average days in inventory by comparing average inventory with sales or revenue numbers. These ratios can be used to evaluate a company's stock replenishment and sales cycles as well as the time it takes to turn inventory into cash.
Inventory turnover is the frequency with which a company sells and replenishes its stock over a specific time frame. It is computed by subtracting the average inventory from sales or cost of goods sold. A business with a high inventory turnover likely has strong sales and a large customer base. Additionally, it suggests that a company has low holding costs and little chance of deterioration or obsolescence. Low inventory turnover may be a sign of a company's weak sales and low product demand. Additionally, it suggests that a company has high holding costs and a high risk of deterioration or obsolescence.
Average days in inventory is the length of time it typically takes for a company to sell all of its inventory. It is computed by dividing the number of days in a period (365 or any other number) by the inventory turnover. An organization with quick-moving products and effective inventory control will have a low average day in inventory. It also suggests that a company has a high level of liquidity and cash flow. An organization's slow-moving items and ineffective inventory management may be indicated by a high average day in inventory. It also suggests that a company's liquidity and cash flow are weak.
Inventory Turnover = Sales / Average Inventory
= $1,200,000 / $200,000
= 6
This means that the company sells and replaces its inventory six times per year on average. Its average days in inventory ratio is:
Average Days in Inventory = 365 / Inventory Turnover
= 365 / 6
= 60.83
This means that it takes about 61 days for the company to sell its entire inventory on average.
Second, average inventory supports organizations' planning and inventory level optimization. Businesses can calculate how much inventory they need to keep on hand to meet consumer expectations and prevent stockouts or overstocking by examining previous data and projecting future demand. This can lower storage costs and waste while enhancing consumer pleasure and loyalty.
Consider a business that is aware that its monthly sales on average are $100,000 and that its monthly inventory on average is $50,000. It is also aware of its lead time, which is 15 days, which is the interval between placing an order and receiving it. Based on this information, the company can calculate its reorder point (the level of inventory that triggers a new order) as follows:
Reorder Point = (Average Daily Sales x Lead Time) + Safety Stock
= ($100,000 / 30 x 15) + $5,000
= $25,000 + $5,000
= $30,000
This means that when the company's inventory level hits $30,000, a new order should be placed. The corporation maintains a safety stock, or additional quantity of inventory, to cover demand and supply fluctuations. Demand fluctuation, lead time unpredictability, service level, and the cost of stockouts are just a few examples of the variables that affect the ideal level of safety stock.
What Are the Challenges and Limitations of Average Inventory?
Average inventory is not without its challenges and limitations. Some of them are:- The real inventory level at any one time might not be represented by average inventory. It is an estimate based on historical data, which may not be precise or indicative of the current condition. For instance, if a corporation sees a rapid increase or decrease in demand or supply, its average inventory may not represent this shift and may result in wrong judgments or inaccurate ratios.
- Seasonal inventory differences might not be taken into account by average inventory. Depending on elements like weather, holidays, festivals, and customer preferences, some firms exhibit cyclical or seasonal patterns in their inventory levels. A toy business might have more inventory before Christmas than after, while a clothes retailer might have more inventory in the winter than in the summer. The study or comparison of several periods may be distorted if average inventory is used since it may not reflect these swings.
- There's a chance that average inventory doesn't take into consideration various inventory categories. Raw materials, work-in-progress, finished goods, and merchandise are just a few examples of the several types or classifications of inventory used by some businesses. The qualities, prices, and turnover rates of each sort of inventory may vary. For instance, finished goods might have a higher value and lower turnover than raw materials, or merchandise might have a higher value and higher turnover than works-in-progress. Using an average inventory may not be able to detect these variations, which could lead to inaccurate or lacking data.
How to Overcome the Challenges and Limitations of Average Inventory?
To overcome the challenges and limitations of average inventory, businesses can use some of the following strategies:- To determine average inventory, use more frequent or precise data points. Businesses can determine the average inventory by using weekly or daily data rather than monthly or quarterly data. This can assist in more precisely and promptly capturing any changes or fluctuations in inventory levels. The complexity and expense of data collecting and processing could, however, potentially rise as a result of this.
- To take into consideration seasonal inventory differences, use weighted average inventory. Businesses can use weighted average inventory in place of basic average inventory to give certain periods distinct weights based on their respective value or contributions to the total inventory level. For instance, a company might give periods with more demand or sales higher weights, and periods with lower demand or sales higher weights. This can assist in minimizing any seasonal peaks or valleys in inventory levels.
- Calculate the average inventory separately for each category of inventory. Businesses might use different average inventory figures for each type of inventory rather than using a single figure for all forms of inventory. More pertinent and detailed information can be provided by helping to distinguish between the traits, prices, and turnover rates of each category of inventory.
