What is Average Inventory Period?
The average inventory period is a usage ratio that calculates the average number of days, over a given time period, goods are held in inventory before they are sold. In other words, it shows how long it takes a company to sell its current inventory. Conversely, it shows how long inventory sits on the shelf and remains unsold.
In this sense, this ratio could also be considered an efficiency ratio.
Average inventory period refers to a financial ratio used to compute the average number of days a company takes before they sell all their current stock of inventory. In other words, AIP is the duration goods are sitting on the shelves for before they’re sold.
Company management can use average inventory period figures to monitor purchasing patterns and sales trends of the stock inventory so that they can easily minimize carrying and storage costs. It can help management to identify fast-moving goods. Thus, the average inventory period is an essential measure of how efficient a company can convert its inventory into sales.
Average inventory period plays a crucial role in the decision-making process by the financial analysts and investors whose primary interest is more profit generation. They review the AIP ratio as it demonstrates the company’s ability to liquidate its stock. A small AIP indicates an efficient company and vice versa.
Average Inventory Period Formula
The average inventory period formula is calculated by dividing the number of days in the period by the company’s inventory turnover.
Average Inventory Period = Days In Period ÷ Inventory Turnover
This equation requires two variables. The number of days in the period can be annual or per-quarter, depending on the company’s interest and inventory turnover.
The next step is to determine the inventory turnover rate. If it’s not provided directly, you can solve for it by dividing the cost of goods sold by the average inventory.
Inventory Turnover = Average Inventory ÷ Cost of Goods Sold
However, you may not always have the average inventory either. You can easily solve for this as well using the following equation.
Average Inventory = (Beginning Inventory + Ending Inventory) ÷ 2
Average inventory period value shows the efficiency of the company in terms of its operations. For instance, a small average inventory period means that the company is more efficient in its operations because it takes less time to turn its stock into cash hence increasing cash flow. A lower DSI is also preferred because it ensures that the company reduces the storage cost.
By selling the whole stock within a short period for the case of foodstuff, consumers are guaranteed fresh and healthy. An increase in the average inventory period shows that the company is becoming inefficient, and this signals for investigation on what could be the possible causes of slow sales.
Average Inventory Period Example
ABC Limited is a 4-year-old, rapidly growing food and beverage company. In the fiscal year 2020, the company published in their financial statements including $450,000 and $550,000 for beginning and ending inventories, respectively. The average inventory for that year was $500,000.
In the fiscal year 2021, the company published had $350,000 and $450,000 for their beginning and ending inventories, respectively. In both years, their cost of goods sold was $5,000,000. Assuming that 2020 and 2021 ended in 365 days, determine the average inventory period of the company.
Now let’s break it down and identify the values of different variables for 2020.
You can calculate the average inventory by dividing the beginning inventory ($450,000) by 2, then add the closing inventory ($550,000). So the average inventory would be $775,000. We can find the inventory turnover by dividing the cost of goods sold ( $5,000,000) by the average inventory.
- Number of Days in Period = 365 days
- Inventory Turnover = 6.45
Finally, we can use our formula to calculate the average inventory period:
Average Inventory Period = 365 ÷ 6.45 = 56.59 days
The company needed 56.59 days to sell all its current stock.
For the 2021 fiscal year, you can use the same methods as above to identify the average inventory as $625,000. And you can use that number to find the inventory turnover rate.
- Number of Days in Period = 365 days
- Inventory turnover = 8
Average Inventory Period = 365 ÷ 8 = 45.63 days
The company needed approximately 45.63 days to sell all its current stock. Company managers can compare past figures with the current ones to find out if the level of efficiency is either going down or up. In 2020, the company was taking about 57 days to sell all their stock. Then, in 2021 the figure reduced to about 46 days. This was an indication that it converting its inventory into cash more efficiently.
Average Inventory Period Analysis
Average inventory period concept is a measure of interest in the management of companies as it informs managers on purchasing happenings and sales trends of various products and ideas. This helps them to know which products are fast-moving and helps in deciding on the volumes of stock to be purchased to reduce associated costs like carrying and storage costs while increasing cash flows.
Average inventory period may not pinpoint exactly the reason why the period the product is staying on the shelves is long. So in such cases, if the AIP was figure was for more than one product, say, five it usually is advisable for the manager to disintegrate the five products and calculate AIP for each product so that he/she can isolate which product is dragging behind the entire company’s sales. From there, management can proceed to investigate the main issue as to why the product is not moving fast and then decide on the way forward.
AIP rate can change throughout the business cycles as a result of seasonality in some industries. For example, retail shops may experience shorter AIP during holidays and longer AIP during the summer period, and this explains why an average inventory period is the best over a certain period as it will factor in both holiday and summer sales trends.
Since we use the same formula to compute AIP across different seasons and products and companies, comparison too should only be made between companies in a similar industry dealing in related products or within the same company so that the truth of the narrative of apples-to-apples comparison be realized.
Practical Usage Explanation: Cautions and Limitations
The average inventory period can also be calculated using the total sales divided by average inventory but is arguably more accurate, as illustrated here, when using cost of goods sold. With either method, when comparing this measure between different companies, it’s imperative that the same method of calculation be used to get the true “apples-to-apples” comparison.
Sometimes, this rate may change throughout different business cycles and may have some seasonality to it in certain industries. Retailers, for example, may experience shorter inventory periods during the holidays and longer inventory periods during the summer months. For this reason, it’s important to calculate the average inventory period using a timeframe relevant to the particular business industry.
Also, keep in mind this measurement alone will not necessarily pinpoint any specific causes for slowing sales or increasing inventory costs but can help identify if there is need for a closer look.
Average Inventory Period Conclusion
- Average inventory period is the average number of days a company takes before they sell all their current stock of inventory
- Average inventory period is a measure of how efficiently a company can convert its inventory into goods into sales.
- A low AIP indicates a more efficient company.
- AIP is usually calculated within one year periods.
- DSI requires two variables: Number of days in period and Inventory turnover.
- Only compare the average inventory period to companies with like industries.