Why is it sometimes better to use an average inventory figure when calculating the inventory turnover ratio?

Inventory turnover is an important metric for evaluating how efficiently a company turns its inventory into sales. By using average inventory, companies can obtain a more accurate measurement of the cost of inventory by smoothing out fluctuations in inventory values over multiple periods.

As a result, inventory turnover can be more effectively monitored, which helps companies plan inventory purchases and measure their sales performance.

How Average Inventory Works

Inventory represents the goods or raw materials that are used in the production of a product. Inventory can also consist of the final product, which are the goods that have been produced and are ready to be sold. 

There are three types of inventory. Raw materials are a type of inventory used in the production of a good, such as copper or steel. Work-in-progress inventory represents the goods that are partially finished and waiting to be completed. For example, work-in-progress inventory might be on the production floor but have yet to be finished, such as an automobile that has yet to be fully assembled. 

Finished goods are the products that have gone through the production process and are ready for sale. Finished goods can also be called merchandise and might include clothing, electronic devices, automobiles, and computers.

Inventory is listed on the balance sheet under current assets, which are short-term assets that are typically used up within one year. When an item in inventory is sold, the cost of the inventory is carried over to the income statement and reported under the line item called cost of goods sold (COGS).

As a result, companies must record the cost of an inventory item when a product is sold. The cost of that inventory item is important because it represents an expense and helps determine how much profit will be generated from the sale of a product. There are various methods in which companies use to determine the cost of an inventory item when products are sold in a particular accounting period. Taking the average cost of the inventory items is one of those methods.

Average Inventory

Inventory management is critical for companies since it helps them keep their costs under control, while it also helps to ensure that ample amounts of inventory are readily available for when a new sale of a product is made.

However, over several months, for example, it can be challenging determining the cost of each inventory item that went into the sale of a company’s products. Companies might buy inventory at various times per year, and in each instance, the cost of the inventory items might be different. For example, automobile manufacturers that use steel in the production of their goods might pay a different price for the steel each time they purchase it. 

Average inventory is used by taking the value of the inventory over multiple periods. By taking multiple inventory purchase points, the value or cost of the overall inventory can be more accurately measured. The average helps smooth out the fluctuations in prices for inventory items such as raw materials, which tend to experience frequent price moves.

Calculating the average inventory can be done as follows:

• Average Inventory = (Previous Inventory + Current Inventory) ÷ Number of Periods

For example, a company might want to calculate the average inventory cost for an entire year. The company could take the inventory value at the beginning or end of each month. All the values would be added together and divided by the number of months to obtain the average inventory cost.

The average inventory calculation could also be calculated for each quarter, for example. The ending inventory balance from the prior quarter could be added to the ending balance of the current quarter with the total being divided by two to arrive at the average inventory.

Inventory Turnover Ratio

Average inventory is often used to calculate inventory turnover, which shows how much inventory is sold over a period of time. By understanding inventory turnover, companies can determine how many times within a period, such as one year, that it took for them to replace their inventory. Inventory turnover can also help companies determine how long it takes to manufacture a product, the length of their sales cycle, and how much sales volume is needed to use up the inventory. 

Inventory turnover can be calculated as follows:

• Inventory Turnover = Cost of Goods Sold ÷ Average Inventory

A high inventory turnover ratio suggests that either the company had strong sales or an insufficient amount of inventory. Conversely, a low inventory turnover implies weak sales or perhaps excess inventory.

Why Average Inventory Is Used in Inventory Turnover

When thinking about the differences between the income statement and balance sheet, one starts to understand why average inventory is used. Income statements cover a period of time, such as a quarter or a single year.

Using an annual 12-month period as an example, the stated cost of goods sold (COGS) figure will be recorded and accumulated throughout the year, and then the average is determined from these numbers. In other words, average inventory is the COGS level that builds from January through December for a company that uses a calendar year as its fiscal full-year period.

In contrast, a balance sheet represents the state of a company’s assets and liabilities at a certain point in time. For the calendar year example above, this same company’s annual inventory level will be the snapshot on December 31. For this reason, taking the average of the inventory levels at the beginning and ending periods of the year is more accurate.

Companies that experience seasonality in their sales also use average inventory in their inventory turnover calculations. Retailers, for example, that record most of their sales during the holiday season would likely need to use average inventory. It wouldn’t make sense to use the inventory value from the first quarter of the year when sales are low to calculate inventory turnover nor would it make sense to take only the fourth quarter in calculating turnover.

Also, many retailers purchase inventory in the summer months to ramp up production for the holidays. As a result, taking the average inventory throughout the year can provide a more accurate reflection of the cost of inventory and smooth out the peaks and valleys associated with seasonality.

Example of Average Inventory and Inventory Turnover

For example, let’s say a retailer had $1 million in sales for the year and $500,000 in COGS. Since the majority of the company’s sales are recorded in the second half of the year, the inventory values vary for each quarter.

Below are the inventory values for each quarter of the year:

• Q1: $10,000
• Q2: $25,000
• Q3: $50,000
• Q4: $100,000 

The average inventory for the year would be calculated by totaling the inventory values from all four quarters and dividing it by the number of periods or four. As a result, the average inventory for the year would be $46,250 (or $185,000 / 4). We can see that using average inventory helps to smooth out the periods in which the inventory values fluctuated. 

The retailer’s inventory turnover would be 10.8, or $500,000 in COGS divided by $46,250 in average inventory. In other words, the company turned over its inventory 10.8 times throughout the year.

If the company wanted to calculate how many days it took to turn over its inventory, it would divide 365 by 10.8 since there are 365 days in the year. So, it took the company 33.8 days on average to sell their inventory (or 365 / 10.8).

*At the time of writing, Ryan C. Fuhrmann did not own shares in any of the companies mentioned in this article.