Average Inventory

Cost of Goods Sold is an income statement account (or perhaps a computation) covering a period of times—such as one year. Inventory is a balance sheet account representing an instant or point in time. Since it could be misleading to divide the Cost of Goods Sold for the entire year by the Inventory balance at an instant at the end of just one day, one should strive to determine the average balance of Inventory during the entire year. In other words, the goal is to calculate an average balance in the Inventory account for the same one-year period as the Cost of Goods Sold.

Often the average balance in the Inventory account for a year is calculated by using the balances on just two days: the beginning of the year balance and the end of the year balance. This could also be misleading because companies' accounting years often end at their slowest time of the year and the balances in Inventory at that time will be very low and not indicative of the year. Expressed another way, if the company has its peak business season in the middle of its accounting year, using the balances in Inventory on two days outside of the peak period may be just as misleading as selecting one day at the end of the accounting year.

In order to obtain an average that is more representative of the entire year, some companies use the Inventory balances at the end of 13 months while others compute a simple average of the 12 monthly averages.

The following illustration shows three computations of the average of the balances in Inventory for a company with a summer busy season.

Date	Balances at 2 points	Balances at 13 points	Monthly Averages
12-31-04	$ 40,000	$ 40,000
1-31-05		60,000	$ 50,000
2-28-05		70,000	65,000
3-31-05		80,000	75,000
4-30-05		100,000	90,000
5-31-05		150,000	125,000
6-30-05		250,000	200,000
7-31-05		300,000	275,000
8-31-05		200,000	250,000
9-30-05		130,000	165,000
10-31-05		60,000	95,000
11-30-05		50,000	55,000
12-31-05	60,000	60,000	55,000
Total	$ 100,000	$ 1,550,000	$ 1,500,000
No. of points	2	13	12
AVERAGE	$ 50,000	$ 119,231	$ 125,000

As you can see, using only two points, the beginning and end of year inventory amounts (December 31, 2005 and the December 31, 2006 balances) results in an average balance of $50,000.

Using 13 points throughout the year results in an average inventory balance of $119,231.

Using the average of the 12 monthly averages results in $125,000.

If you are comparing your company's financial ratios to another company's ratios or to the industry averages, it is important to keep in mind that the financial ratios can vary due to the calculations of averages.

Because the material covered here is considered an introduction to the topic of improving profits, there are many complexities not presented. You should always consult with an accounting professional for assistance with your own specific circumstances.

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