Much of the supply chain deals with the handling of inventory – whether it is planning your inventory in accordance to the amount of demand you have estimated, or sorting it out within your warehouse, or on your store’s shelves. Another important factor when it comes to inventory is calculating one’s average inventory. Average inventory holds much importance in the success of a business and is therefore crucial that an owner understands what it is, how to calculate it, and how it compares to other inventory metrics. If you want to know more about average inventory, you have come to the right place.
What is Average Inventory?
We have already mentioned its importance… but what is average inventory? Average Inventory calculates an estimation of the value of your company’s inventory during a specified time frame. It is used to offset the inventory calculated during sporadic peaks and valleys to provide a better, general understanding of one’s inventory value. It is, thus, advisable to find the mean of one’s inventory values calculated over 2 or more periods of the same time frame.
Average inventory needs to be factored into inventory management if you want these efforts to be successful. Effectively knowing how much your company will be spending and making on inventory during a specific period allows the opportunity and competitive advantage to organize the rest of your capital and costs accordingly. Managing your costs and optimizing your capital minimizes surprises, and allows for seamless business operations. Average inventory improves business performance through allowing a competitive edge achieved through efficiency and optimization of costs, capital, profit, and cash flow.
How to Calculate The Average Inventory
Calculating the average inventory formula follows a fairly simple.
Below is a quick guide on how to work out average inventory:
Average Inventory for more than one month = (Beginning Inventory + Ending Inventory)/2
Let us use the formula for average inventory in a working example:
Your small sweet shop wants to calculate its average inventory for September 2023. You began the month with a total inventory value of $20,000 and ended with a total inventory value of $15,000. Using the formula of average inventory above, let us calculate your average formula for the month:
Average Inventory = ($20,000 + $15,000)/2 Average Inventory = $35,000/2 Average Inventory = $17,500
Average Inventory Calculation Methods
There are a number of methods one can implement when calculating average inventory at cost. We shall be breaking down the FIFO, LIFO, and weighted average methods, their advantages and disadvantages, as well as in which business operation they would be used most appropriately.
FIFO (First-In, First Out):
As discussed in many prior Intuendi articles, the FIFO method of inventory management assumes that the first batch of inventory accepted should be the first sold. FIFO works as it mimics the natural flow of inventory in and out of storage and accurately reflects the current market price of goods. However, it does have its pitfalls when prices start to change rapidly due to major influencing external factors. FIFO is most suitable for businesses that see a rapid overturn or change in inventory, especially when the inventory on hand is perishable goods with short shelf lives such as medicine and raw produce.
LIFO (Last-In, First Out)
Alternatively to FIFO, LIFO assumes that the most recently acquired inventory items should be the first to be sold. The same advantage of selling goods closer to their market price applies to the LIFO method, however, your company can also enjoy tax benefits on unsold items that were priced lower than what they would be currently selling for when originally purchased. It is important to note that this is country-specific, and could fall out of the tax regulations in certain areas. LIFO is most suitable for businesses prone to experiencing inflation.
Weighted Average Cost Method:
This calculates the average cost of all inventory items, whether new or old and is used to value ending inventory and the cost of goods sold (COGS). This method is simple and adaptable but may lead to distortions during periods of significant price fluctuations. It is best used when avoiding the extremes of FIFO and LIFO, or when your company’s environment is characterized by stable pricing.
Average Inventory vs. Other Inventory Metrics
- Average Inventory: Established above, average inventory helps better asses the average investment allocated towards inventory, creating a wider opportunity for stronger cost control and working capital management.
- Service Level: Service level measures the performance of a system, calculating the amount of orders or purchases that can be fulfilled from existing, available inventory. Customer satisfaction is prioritized when using service level as an inventory management method, providing the added benefit of reducing stock-out situations and backorders. Service level and average inventory, when implemented together, are advantageous to a company, as service level focuses on achieving customer satisfaction, and average inventory plays a role in turning this goal into reality. Maintaining a steady average inventory level ensures that inventory items are always available, enabling a high service level rate.
- Inventory Turnover: Inventory turnover looks at how quickly a company can sell out of and replace its stock during a specific period, ultimately assessing the efficiency of the inventory management efforts. This is strengthened when used in conjunction with the average inventory calculation. A company should generally strive towards a high inventory turnover rate while maintaining a low average inventory value.
- Carrying Cost: This is representative of all costs and expenses associated with storing and shipping inventory, including its upkeep and insurance rates. Placing focus on one’s carrying costs aids in identifying some of the unnecessary expenses associated with it, which could be better allocated elsewhere, encouraging businesses to optimize how they carry and store stock. This, furthermore, helps in making informed decisions towards lowering a company’s risk of excess inventory.
Strategies to Optimize Average Inventory
Here are Intuendi’s top tips, tricks, and techniques when it comes to optimizing average inventory:
- Demand Forecasting: Something you will read about a lot in our articles, demand forecasting makes use of historical data, market trends, and consumer analysis to accurately forecast a company’s demand. Its power when optimizing average inventory lies in the opportunity it provides to businesses to align their inventory levels in accordance with their findings, resulting in reduced excess stock and stock-out situations. Using AI demand forecasting software allows us to reach the most granular level of forecasting.
- ABC Analysis: This method of prioritization allows companies to optimize their efforts based on the importance of certain items. Stock is split between 3 categories – A, B, and C- labelled in order of importance and value. This allows for concentrated efforts to be placed on higher-value items, rather than wasting time, energy, and resources on lower value stock.
- Just-In-Time (JIT) Inventory: This method of ordering inventory assumes that a company should only order inventory when they are nearing sell-out of their current stock. For this to be most effective, it is important to factor in average lead and travel times. This minimizes holding costs and reduces excess inventory as stock is only ordered when it is needed, ready to be moved onto shelves, and finally, out of the store.
- Inventory Technology: Our specialty! Intuendi highly recommends investing in inventory technology, as we have seen the difference this has made. We offer real-time visibility and tracking of inventory, along with reorder alerts, reducing the majority of the inventory management heavy work – leave this to us!
Efficient inventory management is strengthened by knowing your average inventory – it is optimized when you can plan your assets, capital, and costs accordingly. Having a firm grip on how you spend your money, and where you spend it, allows for further in-depth analysis of how you can be spending it better, improving cash flow, reducing costs, and enhancing customer satisfaction. Efficient inventory management, including maintaining an optimal average inventory level, can significantly impact your bottom line. By implementing the discussed strategies, you can reduce costs, improve cash flow, enhance customer satisfaction, and ultimately boost profitability. Regularly monitoring and adjusting your inventory management practices will help your business thrive in a competitive marketplace and achieve long-term success. Start by identifying areas where improvements can be made and gradually implement changes for tangible benefits.
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