The average number of days that pass before a company sells its inventory balance
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The average age of inventory represents the average number of days that pass before a company sells its inventory balance. It is an important working capital efficiency metric that is also referred to as days’ inventory on hand (DOH).
How to Calculate the Average Age of Inventory
The average age of inventory is calculated by taking the average inventory balance and dividing it by the cost of goods sold (COGS) for the period and then multiplying it by 365 days. The average age of inventory is calculated over a period of one year.
Average Inventory Balance – The average of the inventory balance at the beginning of the year and the inventory balance at the end of the year.
Cost of Goods Sold (COGS) – The direct costs associated with producing goods that are sold by a company. It includes direct raw materials and direct labor used to produce the goods.
Importance of the Average Age of Inventory
From an Investor’s Perspective
Investors can use the average age of inventory to evaluate a company’s operations. The average age of inventory gives insight into how fast a company is turning over its inventory. Generally, a faster inventory turnover (low average age of inventory) means that a company is efficiently selling inventory.
However, if inventory turnover is too high, it can be a sign that the company is selling inventory too quickly and may experience inventory shortages. Inventory shortages represent lost sales and are extremely detrimental to a company’s profitability.
If a company reports a low inventory turnover (high average age of inventory), it can indicate that a company is not optimally managing its inventory or that its inventory is difficult to turn over.
Inventory efficiency is an important metric for investors to evaluate for companies, especially if they operate in industries where inventory turnover is important. An example is the food industry.
From the Management’s Perspective
The average age of inventory is an important metric for managers to use as well. By monitoring the average age of inventory, managers can gain insight into what their pricing strategy should be. If their average age of inventory is lower than other companies, then the company may be pricing products too low. However, if their average age of inventory is higher than other companies, then the company may be pricing its products too high, and therefore, is not selling products fast enough.
Additionally, the average age of inventory can influence decisions on creating marketing strategies, such as offering discounts and promotions, selling aging inventory, and increasing cash flow. If the average age of inventory gets very high, then the inventory is exposed to obsolescence risk.
Obsolescence risk essentially is the risk that a product or service may become obsolete and will not be able to be sold for expected market value. The product may need to be sold at a steep discount, perhaps even below its cost.
As an example, the age of inventory is very important in the food industry – especially for perishable food items that can expire, such as fresh produce, meat, and dairy. The management of companies who sell these products must pay close attention to their average age of inventory since if their inventory spoils, it is a complete write-off and can result in substantial losses.
Assume that you are an investor that is deciding on whether to invest in two food retail companies.
Company A reports an average inventory of $200,000 and COGS of $1,000,000.
Company B reports an average inventory of $100,000 and COGS of $1,500,000.
Assuming all other variables are equal, which company is a more attractive investment?
Average Age of Inventory (Company A): ($200,000 / $1,000,000) x 365 = 73.0 days
Average Age of Inventory (Company B): ($100,000 / $1,500,000) x 365 = 24.3 days
It appears that Company B shows a much lower average age of inventory. What does it tell us?
Given that the food retail industry can experience spoilage of products, it is more favorable to aim for a lower average age of inventory, so there is less chance that food products may become spoiled.
Therefore, Company B appears to be a more attractive investment.
The management of Company A may want to consider decreasing prices of products or creating discounts and promotions to sell their inventory quicker.
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