Unpacking the Average Inventory Approach

Average Inventory, also called Average Stock, is a nifty way companies keep track of their stuff. It’s an inventory management and accounting trick where the cost of the stuff getting moved around is figured out using the average cost of all the stuff the company has stocked up.

Let’s break it down real simple-like. Say a company’s got 100 thingamajigs that cost them $10 each. Then they go and buy 50 more thingamajigs, but the price has gone up to $12 each. If they wanted to send out 30 thingamajigs to their stores, with Average Inventory, they’d calculate the cost like this:

Total thingamajigs: 100 + 50 = 150
Total cost: (100 x $10) + (50 x $12) = $1,600
Average cost per thingamajig: $1,600 ÷ 150 = $10.67

So, the cost of those 30 thingamajigs getting sent out would be recorded as 30 x $10.67 = $320.

Why Average Inventory is the Bee’s Knees

Companies dig Average Inventory for a bunch of reasons:

It’s easy peasy. No need to keep track of which thingamajig came from which batch at which cost. Just average it all out!
It smooths out the ups and downs. Prices go up, prices go down, but with Average Inventory, the cost kind of evens out over time.
It’s great for stuff that’s hard to tell apart. If all your thingamajigs are mixed together and you can’t tell which is which, Average Inventory is the way to go.

When Average Inventory Might Not Be So Hot

Now, Average Inventory isn’t always the cat’s pajamas. Sometimes, it can get a company into hot water:

If prices are jumping around like a kangaroo, the average cost might not paint a pretty picture of what’s really going down.
If a company’s got stuff that’s sitting around for ages, the average cost might be way off from what they could sell it for now.
The tax folks might not be too keen on Average Inventory. They might want companies to use other methods that show the real nitty-gritty of what’s what.

Crunching the Numbers with Average Inventory

Alrighty, let’s get into the meat and potatoes of how companies actually use Average Inventory.

Step 1: Figure Out the Starting Average Cost

First things first, companies need to know the average cost of their stuff at the beginning. They take the total cost of their inventory and divide it by the number of units. Bam! Starting average cost.

Step 2: Adjust the Average Cost as Stuff Comes and Goes

Whenever a company buys more stuff, they’ve gotta recalculate the average cost. They add the cost of the new stuff to the total cost of the stuff they already had, then divide that by the new total number of units.

And when they sell or use up some stuff, they use the most recent average cost to figure out the cost of the stuff that’s leaving.

Step 3: Keep On Keepin’ On

Companies just rinse and repeat steps 1 and 2 as stuff keeps flowing in and out. The average cost gets updated with each purchase and each sale or use.

A Quick Example

Let’s say Thingamajig Inc. starts off with 1,000 thingamajigs that cost a total of $10,000. The starting average cost is $10 per thingamajig.

They sell 100 thingamajigs. The cost of those is 100 x $10 = $1,000. They’ve got 900 thingamajigs left, worth a total of $9,000.

Then they buy 500 more thingamajigs for $6,000. The new average cost is:

Total cost: $9,000 + $6,000 = $15,000
Total units: 900 + 500 = 1,400
New average cost: $15,000 ÷ 1,400 = $10.71 per thingamajig

And on and on it goes, with the average cost getting updated each time.

Average Inventory in the Real World

Average Inventory isn’t just some nerdy accounting thing. It’s used by all sorts of companies in all sorts of industries.

Manufacturers

Manufacturers use Average Inventory to keep track of the cost of their raw materials and their finished products. It helps them figure out how much they’re spending and how much they should be charging.

Retailers

Retailers use Average Inventory to manage the cost of the products they’re buying from suppliers and selling to customers. It’s especially handy for stuff like clothes or food that might spoil or go out of style if it sits around too long.

Service Providers

Even service providers sometimes use Average Inventory! Think about a beauty salon that uses a lot of hair dye or a mechanic that goes through a ton of oil. They can use Average Inventory to track the cost of those supplies.