Ending inventory, defined as the value of sellable inventory remaining at the end of anaccounting period, is a crucial metric for any business that sells goods. Accuratelyassessing ending inventory is essential for a clear picture of the company’s assets,profit and tax liability. Businesses using inventory management software don’t need toactually calculate ending inventory, since they have a constant view of it, but they willreport inventory level for accounting purposes. Companies can use a variety of methods tocalculate ending inventory, the choice of which affects both the company’s balancesheet and its income statement.
What Is Ending Inventory (or Closing Inventory)?
Ending inventory, also known as closing inventory, is the value of goods that a company hasavailable for sale at the end of a given accounting period. Calculating ending inventory isimportant for businesses in virtually every industry. Understanding how much stock is leftat the end of an accounting period helps companies get a better picture of their currentassets and gross profit, whether their inventory management systems are accurate and whetherthey should adjust their ordering and production to align more closely with demand.
Key Takeaways
- Ending inventory measures the value of goods a business has available to sell at the endof a given accounting period.
- The method used to calculate ending inventory has implications for the company’sbalance sheet, profit and tax liability.
- Many companies use the first in, first out (FIFO) or weighted average cost (WAC) methodsfor accuracy and simplicity.
- The gross profit and retail methods can be used to estimate ending inventory whenaccurate inventory counts are not feasible.
- Inventory management software can automate inventory tracking and simplify thecalculation of ending inventory.
Ending Inventory Explained
To calculate ending inventory, businesses need to track the number of inventory items theyhave. This tracking can be performed automatically using inventory management software andwhen necessary confirm those numbers using physical inventorycounts. Companies then choose an appropriate method to assign a value to those itemsin order to calculate the total value of ending inventory. Where an accurate count ofinventory items is not feasible, it may be possible to estimate ending inventory from otherbusiness data.
Why Is Ending Inventory Important?
Tracking ending inventory is important for business management, accounting and tax purposes.Ending inventory can be among the company’s biggest assets, so it’s important toensure it is accurately tracked and valued. The choice of inventory valuation method alsoaffects the company’s cost of goods sold (COGS), which, inturn, has an impact on the company’s gross and net profit and resulting tax liability.Ending inventory has implications for business strategy and planning. In the retail sector,accurately assessing ending inventory as part of a broader inventory management process maybe critical to a company’s survival. Efficient inventory management helps companiesensure they have enough goods to supply customers and set appropriate pricing and salesstrategies.
How Is Ending Inventory Used?
Determining the value of ending inventory helps companies get a clear picture of theirfinancial health. The calculation of ending inventory affects both the company’sbalance sheet and income statement, which are two of the primary financial statementsclosely scrutinized by executives, lenders and investors. Ending inventory is recorded as acurrent asset on the balance sheet at the end of eachperiod; for retailers and some other businesses, it is often the most valuable asset.
The cost of inventory that’s sold during each period is subtracted from endinginventory and added to the company’s COGS. This directly affects the gross profit reported on the income statement, whichis calculated by subtracting COGS from net sales revenue. Ending inventory valuationtherefore affects the amount of income tax the company needs to pay for the period. Anaccurate measure of ending inventory is important not only for the current period but alsofor future periods because each period’s ending inventory is used as the beginninginventory for the next period.
Companies can also compare their calculated ending inventory value with actual physicalinventory to identify potential problems, such as inventoryshrinkage.
How to Calculate Ending Inventory
The basic method for calculating ending inventory is straightforward. You simply take thebeginning inventory at the outset of the current accounting period, add the cost of newpurchases and subtract the cost of goods sold (COGS).
Ending inventory formula: The basic ending inventory formula is shown below.Although the formula is simple, the way in which a business calculates COGS plays a majorrole in the ending inventory value.
Ending inventory = beginning inventory +net purchases - cost of goods sold (COGS)
- Beginning inventory is the value of inventory at the start of theperiod. It is equal to the ending inventory value from the previous accounting period.
- Net purchases is the cost of any items that a company has purchased andadded to its inventory during the accounting period.
- COGS is the cost of manufacturing and/or purchasing the finished goodsthat were sold during the period.
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Ending Inventory Methods
There are multiple methods for calculating ending inventory, each with its own advantages anddisadvantages. All valuation methods usethe basic ending inventory calculation formula shown above. Many companies use the first in,first out (FIFO), or weighted average cost (WAC) methods as they tend to be more accuratefor their purposes and may be simpler to apply.
First in, first out (FIFO). The FIFO method assumes that items are sold inthe order they were ordered. It therefore calculates COGS — the cost of the goods thatweresold during the period — based on the inventory that was purchased earliest. Thisapproachfollows the way many companies actually operate, selling older items first to make space fornewer goods in their inventory. Because the prices of materials and other inventory tend toincrease over time, this method often produces a lower COGS and higher gross profit thanother methods of calculating ending inventory. The higher profit can mean a greater incometax burden for the current period.
| FIFO PROS | FIFO CONS |
|---|---|
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Last in, first out (LIFO). Last in, first out (LIFO) assumes that the mostrecently purchased inventory was sold first. When prices are rising, LIFO increases COGS andtherefore results in a lower gross profit and income tax bill for the current period. Thehigher COGS also results in a lower ending inventory value. While LIFO is allowed under U.S.Generally Accepted Accounting Principles, it is not allowed under International FinancialReporting Standards (IFRS). In other words, it can be used in the U.S. but not in many othercountries.
| LIFO PROS | LIFO CONS |
|---|---|
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Weighted average cost (WAC). With this method, a business simply averagesall inventory costs to calculate COGS and ending inventory. WAC is particularly useful whena company sells many identical items. In these cases, it simplifies calculation of endinginventory because there’s no need to track the cost of individual inventory purchases.It’s less useful when the company sells many different products with widely differingprices and costs.
| WAC PROS | WAC CONS |
|---|---|
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Gross profit. The gross profit method is used to estimate ending inventoryvalue in situations where it’s not possible or desirable to measure the actual numberof inventory items that the company holds. It can be used to get a rough snapshot ofinventory value during the interval between physical inventory counts, or to estimate theinventory remaining after losses due to fire, flood or theft.
This method uses the company’s expected gross profit margin for the current period as astarting point for estimating COGS and ending inventory. Companies often use theirhistorical gross profit margin as a guideline for their current expected gross margin. Acompany’s gross profit margin isits gross profit expressed as a percentage of net sales.
Here are the steps to calculate gross profit:
- Multiply the net sales during the current period by (1 - expected gross profit margin)to obtain an estimate of COGS.
- Apply the standard inventory valuation formula: Add up the period’s beginninginventory and the cost of all further inventory purchases to date, and subtract theestimated COGS to obtain the ending inventory.
| GROSS PROFIT PROS | GROSS PROFIT CONS |
|---|---|
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Retail method. The retail method is used by retailers to estimate the valueof their merchandise at a specific point in time. Retailers may be likely to use this methodif their business involves selling large volumes of low-cost items, making accurateinventory counts difficult. It uses the cost-to-retail ratio, which is the ratio of thetotal cost of goods available for sale divided by the retail value of those goods. Themethod is most useful for retailers that apply a standard markup percentage to all of theitems they buy. For example, if a company typically buys inventory for $100, applies a 25%markup and sells the goods for $125, its cost-to-retail ratio is $100/$125 = 80%.
Here are the steps to calculate:
- Multiply net sales for the period to date by the cost-to-retail ratio to obtain anestimate of COGS.
- Use the standard inventory valuation formula: Add together the period’s beginninginventory plus the cost of additional inventory purchases to date, and subtract theestimated COGS to get your ending inventory.
| RETAIL PROS | RETAIL CONS |
|---|---|
|
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Examples of Ending Inventory
The fictitious company 123 Holdings needs to calculate ending inventory to prepare financialstatements at the end of the current period. The company started the current quarter with100 units of inventory, all of which were purchased at $10 each. During the quarter, thecompany sold 200 units. It replaced them with three additional batches of inventorypurchased at different prices, leaving the company with 100 inventory items at the end ofthe period.
| Number of units | Unit cost | Total Cost | |
|---|---|---|---|
| Beginning inventory | 100 | $10 | $1,000 |
| Purchase #1 | 50 | $12 | $600 |
| Purchase #2 | 50 | $15 | $750 |
| Purchase #3 | 100 | $16 | $1,600 |
| Beginning inventory plus net purchases | $3,950 | ||
The next three examples show how the company can calculate its ending inventory value usingthe FIFO, LIFO and WAC methods. For each example, the same basic formula is used tocalculate ending inventory:
Ending inventory = beginning inventory +net purchases - COGS
Two more examples follow that illustrate the gross profit and retail methods.
Example 1: FIFO
The first step is to calculate COGS for the 200 items sold during the quarter. Using FIFO,the assumption is that these were the earliest items purchased:
- 100 items were purchased at $10 each as part of the beginning inventory, for a totalcost of $1,000.
- 50 items were purchased at $12 each for a total of $600.
- 50 items were purchased at $15 each for a total of $750.
- Purchase #3 is not part of the calculation because they were the last items in andweren’t sold.
COGS, therefore, is $2,350 ($1,000 + $600 + $750) and ending inventory is $1,600 ($3,950 -$2,350).
Example 2: LIFO
With LIFO, COGS for the 200 sold items is based on the most recent purchases:
- 100 items were purchased at $16 each for a total of $1,600.
- 50 items were purchased at $15 each for a total of $750.
- 50 items were purchased at $12 each for a total of $600.
- Beginning inventory is not part of the calculation because they were the first items inand weren’t sold.
COGS, therefore, is $2,950 ($1,600 + $760 + $600) and ending inventory is $1,000 ($3,950 -$2,950).
Example 3: WAC
With WAC, the company assigns the same weighted average cost to every unit, whether sold orunsold.
- 300 units were purchased for a total cost of $3,950, giving a weighted average cost perunit of $13.17 ($3,950 / 300).
COGS, therefore, is $2,633 (200 x $13.17) and ending inventory is $1,317 ($3,950 - $2,633).
Example 4: Gross profit method
Components distributor Widgets Wholesale Inc. was hit by a devastating warehouse fire thatdestroyed much of its inventory. The company wants to quickly estimate the value of itsremaining inventory. It uses the gross profit method to estimate ending inventory based onits net sales and expected gross profit margin.
- Beginning inventory = $500,000
- Net purchases = $250,000
- Net sales = $300,000
- Expected gross profit margin (based on historical business performance) = 40%
The company uses the gross profit method formula to estimate COGS: net sales x (1 - expectedgross profit margin). Estimated COGS, therefore, is $180,000 ($300,000 x 60%).
The company then applies the standard ending inventory valuation formula: beginning inventory+ net purchases - COGS. Estimated ending inventory, therefore, is $570,000 ($500,000 +$250,000 - $180,000).
Example 5: Retail method
All Cheaper Stuff Inc. sells thousands of low-cost items through a chain of retail stores,applying a standard markup of 25% to the items it buys. Because it would be incrediblydifficult and time-consuming to obtain an exact inventory count, it uses the retail methodto estimate ending inventory.
- Beginning inventory = $400,000
- Net purchases during the current period = $250,000
- Net sales = $300,000
- Cost-to-retail ratio (COGS divided by retail value of goods) = 80%
The first step to calculate estimated COGS: net sales x cost-to-retail ratio. Estimated COGS,therefore, is $240,000 ($300,000 x 80%).
The company then uses the basic ending inventory valuation formula: beginning inventory + netpurchases - COGS. Estimated ending inventory, therefore, is $410,000 ($400,000 + $250,000 -$240,000).
Calculate Ending Inventory With Inventory Management Software
As a business grows, inventory management can become extremely complex. Accuratelycalculating ending inventory may involve tracking large numbers of items as well as theirpurchase prices and associated costs. Manually tracking this inventory with spreadsheets isextremely labor-intensive and error-prone, which is why many businesses use inventorymanagement software to automate the process. Comprehensive cloud-based inventory managementsystems can automatically track inventory in real time across all locations. Whether acompany operates locally or in many markets, leading inventorymanagement solutions scale with the organization to ensure ending inventorycalculations are accurate and based on up-to-date inventory and sales data. This helpscompanies optimize inventory levels, reduce cost, improve cash flow and profitability, andincrease customer satisfaction.
Conclusion
Ending inventory is a critical metric for any company that sells physical goods, affectingboth the balance sheet and income statement. It’s important to choose a valuationmethod that matches the company’s needs — the choice can affect the stated valueofthe company’s assets as well as its profit and the amount of taxes it owes. Inventorymanagement software can help businesses track ending inventory more easily while reducingthe potential for manual error.
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Ending Inventory FAQs
What should be included in ending inventory?
Ending inventory is the value of finished sellable goods at the end of a given accountingperiod. It takes into account the beginning inventory at the start of the period, anypurchases during the period and the cost of the items sold during the period.
What is current period’s ending inventory?
The ending inventory for a current accounting period is equal to beginning inventory from thesame period plus all purchases made during that period, minus the total cost of goods sold(COGS) in the period.
Is ending inventory an expense?
Ending inventory is an asset, not an expense. When inventory is sold, its cost is thentreated as an expense and is added to the company’s cost of goods sold (COGS) for theperiod.
How do you calculate beginning and ending inventory?
Beginning inventory is equal to the ending inventory from the previous accounting period.Ending inventory is calculated by adding the period’s net purchases to the beginninginventory, then subtracting cost of goods sold (COGS). Although all methods for calculatingending inventory use this formula, they calculate COGS in different ways and may yielddifferent values for ending inventory.
