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The average inventory investment period measures the amount of time it takes to convert a dollar of cash outflow, used to purchase inventory, to a dollar of sales or accounts receivable from the sale of the inventory. The average investment period for inventory is much like the average collection period for accounts receivable. A longer average inventory investment period requires a higher investment in inventory. A higher investment in inventory means less cash is available for other cash outflows, such as paying bills.
The average inventory investment period is calculated by dividing your present inventory balance by your average daily cost of goods sold:
| Average Inventory Investment Period = |
Current Inventory Balance
Average Daily Cost of Goods Sold |
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The average daily cost of goods sold is computed by dividing your annual cost of goods sold amount by 360:
| Average Daily Cost of Goods Sold = |
Annual Cost of Goods Sold
360 |
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The average inventory investment period can be a useful tool to help you manage your cash flow. Using the annual cost of goods sold amount and inventory balance from a prior year's balance sheet is usually accurate enough for analyzing and managing your cash flow. However, if more recent information is available, such as the previous quarter's cost of goods sold information, then use it instead. Be sure to compute the average daily cost of goods sold correctly using the number of days actually reflected in the cost of goods sold figure. For example, 90 should be used if a quarterly cost of goods sold amount is used.
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Michael Angelo operates an art supply shop. All sales are cash sales. According to Michael's tax return filed last year, his cost of goods sold amount for the year was $195,000. Last year's ending inventory balance was $51,500. Michael's average investment period in inventory is calculated as follows:
Michael's average cost of goods sold is $542 per day: |
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The average investment period in inventory is 95 days:
For Michael's previous year, it took 95 days to convert a dollar invested in inventory to a dollar of sales. If Michael's business has not changed drastically from the previous year, the cash outflow from the purchase of the inventory will not create a cash inflow from the sale of the inventory for 95 days, on average.
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