How to Calculate Months Supply of Inventory
Understand how to calculate months supply of inventory for better stock management and operational insights.
Months supply of inventory is a metric used to assess the efficiency of a business’s inventory management. It indicates the duration, in months, that a company could continue its sales operations using only its current stock, assuming no new inventory is acquired. This calculation provides insights into how effectively a business balances its inventory levels against its sales demand. Understanding this figure is important for maintaining operational efficiency and ensuring sound financial health within an organization.
Key Data for Calculation
Calculating months supply of inventory requires two primary data points: average inventory and cost of goods sold (COGS). Average inventory represents the typical value of inventory a business holds over a specific period. This figure is generally more stable and reflective of actual inventory levels than a single point-in-time inventory count, as it smooths out daily or weekly fluctuations. To determine average inventory, businesses typically sum the beginning and ending inventory values for a given period and divide by two. Inventory values are recorded at cost and can be found on a company’s balance sheet.
The second data point is the cost of goods sold (COGS), which represents the direct expenses incurred by a business in producing or acquiring the goods it sells. These direct costs include raw materials, direct labor, and manufacturing overhead. For businesses that purchase finished goods for resale, COGS includes the purchase price and shipping costs.
Expenses not directly tied to production, such as marketing or rent, are excluded. This information is found on a company’s income statement, where it is subtracted from revenue to calculate gross profit. COGS is used because inventory is valued at cost, ensuring consistency.
Performing the Calculation
The formula for months supply of inventory involves dividing average inventory by the average monthly cost of goods sold. Since COGS is often reported annually, it must first be converted into a monthly figure by dividing the annual COGS by 12. This conversion ensures the sales rate aligns with the monthly inventory supply metric.
For example, consider a business with an average inventory value of $75,000 for the past year. If the company’s total cost of goods sold for that same year was $450,000, the first step is to determine the average monthly COGS. Dividing $450,000 by 12 months yields an average monthly COGS of $37,500. Next, divide the average inventory of $75,000 by the average monthly COGS of $37,500. The resulting calculation shows a months supply of inventory of 2.0 months, indicating that the business holds enough inventory to cover two months of sales at its current pace.
Understanding the Calculated Figure
The calculated months supply of inventory provides valuable insights into a business’s operational efficiency and financial health. A high figure suggests excessive inventory relative to sales demand. This ties up working capital and increases carrying costs, such as storage, insurance, and potential obsolescence.
Conversely, a very low months supply figure might indicate insufficient inventory. While this minimizes carrying costs and frees up capital, it risks stockouts. Running out of popular products can lead to lost sales, dissatisfied customers, and market share decline. An optimal months supply varies by industry and business model, with some sectors needing higher levels due to long lead times or seasonal demand.
Monitoring months supply of inventory helps businesses make informed decisions on purchasing, production, and pricing strategies. It allows management to assess if inventory levels align with sales forecasts and customer demand, optimizing cash flow and minimizing waste. Regular analysis helps companies adjust strategies to balance sales growth without unnecessary costs or stockouts.