If you own a business, inventory is one of your primary assets. Inventory is a word that gets used a lot in business, but what exactly does it mean? Inventory includes the goods available for sale and the raw materials used to produce those goods for sale. It can also include raw materials in the process of being turned into goods that will eventually be sold. Inventory is a key revenue creator for companies because the turnover or sale of inventory is one of a business's primary sources of revenue generation as well as earnings for the company's shareholders.
Calculating a company's average inventory can be reasonably simple. If you want to estimate the value or number of a particular set of goods during two or more specified periods (typically a month), you add the inventory from each month together, then divide by the number of months. For example, if you wanted to determine the average inventory for the past three months, you would add up the inventory from each month, then divide that number by three. So if you have $10,000 worth of inventory in January, then $8,000 in February, the average inventory for those two months would be $10,000 + $8,000 ÷ 2 (months) = average inventory. The average inventory in this example is $9,000.
Types of Inventory
The complicated part of determining an average inventory is often counting the inventory itself. Generally, inventory is categorized as raw materials, work-in-progress and finished goods. Raw materials might include aluminum and steel for making cars, cotton or other materials for making clothing and flour for bakeries that make bread.
Inventory can also be the work-in-progress or partially finished goods waiting to be turned into products for sale, which is the inventory on the production floor. A halfway-assembled automobile or a pair of jeans being sewn are two types of work-in-progress inventory.
Finished goods that are ready for sale are also a type of inventory. Typically referred to as "merchandise," common examples of this type of inventory include television sets, clothing and automobiles.
Three Methods of Valuing Inventory
There are three ways to value a company's inventory.
- FIFO, which stands for First In, First Out, says the value of the cost of goods sold should be based on the cost of the earliest purchased materials. The carrying cost of remaining inventory is based on the cost of the most recently purchased materials.
- LIFO, or Last In, First Out uses an opposite method to FIFO. LIFO says the cost of goods sold is valued using the cost of the most recently purchased materials, while the value of the remaining inventory is based on the earliest purchased materials.
- The weighted average method looks at the average of goods sold and the average cost of the inventory.
Calculating Inventory Turnover Ratio
Calculating average inventory is important, in part, because you need that calculation to determine the inventory turnover ratio. The inventory turnover ratio is key because it shows how much inventory is being sold over a set period. The inventory turnover formula is:
Cost of Goods Sold ÷ Average Inventory ÷ Inventory = Inventory Turnover Ratio
It's essential to use the average inventory when determining turnover because companies might have higher or lower inventory levels at certain times in the year. For example, some retailers will have higher inventory during the holiday season, and lower inventory after the holidays.
COGS, or Cost of Goods Sold, measures the production costs of goods and services for a business. It can include the cost of materials, labor costs related to creating the products and any factory overhead or fixed costs used in the production of goods.
Having a high inventory turnover is a good thing because it means a company is selling goods quickly and there’s demand for their product.
If a company has a low inventory turnover, it's likely that sales are down and people no longer want the company's products.
Inventory turnover can also be a good indicator of how well a company is managing its stock. If the company has overestimated demand for their products and has purchased too many goods, this will be shown by low turnover. However, a high inventory can also reveal mismanagement. If turnover is too high, the company might not be buying enough inventory and may be missing out on sales opportunities.
Ideally, inventory and sales should be in sync. A company can waste money by holding on to inventory that isn’t selling. Inventory turnover is an important indicator of sales effectiveness but also can help a business manage operating costs more efficiently.
Importance of Average Inventory
If you begin to consider the differences between the income statement and balance sheet, you can understand the importance of using average inventory when determining inventory turnover.
Income statements only cover a particular period, such as a quarter or a single year. A balance sheet, on the other hand, shows a firm’s assets and liabilities at a certain point in time. A company's annual inventory level will be more accurate if it is averaged throughout the entire year, rather than looking at a single month.
Again, average inventory is particularly useful for companies that are seasonal. Even big chain stores like Target and Walmart adjust their inventory quite a bit during the year. Target's inventory in July, for example, is lower than it is in November and December when holiday shopping is in full swing. Using average inventory can help smooth out these two different periods.
Problems With Average Inventory
There are a few problems with using the average inventory calculation.
- Month-end basis: Because average inventory is based on the month-end inventory balance, this calculation may not be representative of the average inventory balance on a daily basis. A company that traditionally has a huge sales push at the end of each month to meet its sales forecasts, for example, may have shown a drop in month-end inventory levels well below their usual daily amounts. This drop can be misleading.
- Seasonal sales: Companies that have big swings in their seasonal sales may end up with wonky inventory results. A company may show abnormally low inventory balances at the end of the main selling season, and a huge increase in inventory balances just before the start of the main selling season.
- Estimated balance: Some companies average the month-end inventory balance rather than basing it on a physical inventory count. If this method is used, then the averaging calculation may itself be based on an estimate. This makes the average inventory amount less valid.
Useful for Revenue Comparison
While there are some problems with the average inventory approach, it is useful in many ways. One helpful aspect of average inventory is that it allows a business to compare inventory with revenues. Revenues are usually presented in the income statement for both the most recent month, and also for the year-to-date. A business owner or accountant can calculate the average inventory for the year-to-date and then match the average inventory balance to year-to-date revenues, which will reveal how much inventory investment was needed to support a given level of sales.