Calculating Ending Inventory: Methods and Formulas Explained

Calculating ending inventory is a critical task. You’ll use it to determine your cost of goods sold (COGS), assess the business’s financial health, and plan production and purchasing. Accurate ending inventory is the foundation you need to optimize your inventory levels.

The cost flow assumptions you adopt in calculating ending inventory have a major bearing on the balance sheet and income statement. Regardless of the size of your business, you must understand the methods used for calculating ending inventory. Inventory valuation methods significantly affect your bottom line and inventory holding.

What is ending inventory?

Ending or closing inventory is the value of goods that have not been sold or used by the end of an accounting period. It is the stock on hand after accounting for all production and sales.

Ending inventory affects the balance sheet, where it is a current asset. On the income statement, ending inventory influences the COGS and gross profit.

How ending inventory affects the cost of goods sold

Ending inventory is directly related to the total cost of goods sold during an accounting period. The formula below illustrates this relationship.

COGS = Starting inventory + Purchases – Ending Inventory

Where:

• Beginning inventory: The value of the inventory at the start of the period.
• Purchases: Inventory bought during the period.
• Ending inventory: Inventory remaining at the end of the period.

COGS is the cost of producing the goods that have been sold. It is subtracted from revenue to calculate gross profit. Higher-ending inventory delivers lower COGS and higher gross profit.

Inaccurate ending inventory can have serious financial implications. It affects the balance sheet, financial ratios, and the amount of tax you pay.

Ending inventory calculations

The inventory value depends on the costing, or inventory valuation method. There are several valuation methods.

• First-In, First-Out (FIFO): Assumes that the oldest items are sold first
• Last-In, First-Out (LIFO): Assumes that the most recently acquired items are sold first.
• Weighted Average Cost: Allocates the same cost to each item by spreading the purchase cost across all inventory items.
• Specific Identification: Used when inventory items can be identified and valued separately. This method is used for large, unique, or expensive items, like motor vehicles.

What is the formula to calculate ending inventory?

The ending inventory formula follows:

Ending Inventory = Beginning Inventory + Net Purchases – COGS

Where:

• Beginning inventory: The closing inventory for the previous month
• Net purchases: Items bought and placed in stock during the period
• COGS: The cost of the goods manufactured or purchased and sold during the period

What are the steps to calculate ending inventory

There are five simple steps for calculating the ending inventory:

1. Collect beginning inventory information

The first step is to establish the opening inventory value. This is the inventory on hand at the start of the accounting period. You should find this value on the previous period’s balance sheet and carry it over to the new balance sheet from the end of the last period.

2. Record purchases or production

Record all inventory purchases and the production costs of goods made during the period. Purchases must include raw materials, finished goods, or work-in-progress items added into stock and ready to sell. Accurately track these additions. They are used to calculate the total inventory available for sale or use.

3. Account for sales or usage

Subtract COGS or the cost of items used from the total available inventory. Track all sales or inventory used. COGS must include all direct expenses related to the production or purchase of the goods sold during the period.

4. Establish the cost flow assumption

Choose the appropriate inventory valuation method. The method will impact the calculation of ending inventory, especially when prices fluctuate.

5. Calculate ending inventory

Finally, calculate the ending inventory by subtracting the cost of goods sold (COGS) from the total inventory available. The calculation may vary depending on the cost flow assumption chosen.

This is the value of the unsold or unused inventory at the end of the accounting period. It appears on the balance sheet as a current asset.

Methods for calculating ending inventory

Businesses can choose from four inventory valuation methods. The method affects the COGS and the ending inventory. Each method has advantages and implications for tax liability, profitability, and inventory value.

FIFO (First-In, First-Out)

FIFO assumes that the first items added to inventory are the first sold. This method is often used with perishable items or those subject to obsolescence. Under these circumstances, older items must be used or sold before newer ones. Under FIFO, the value of the oldest purchased items is added to COGS. The ending inventory will thus consist of the most recently bought goods. In inflationary times, expenses are lower and net income higher using FIFO. Ending inventory is higher.

This example illustrates FIFO in action.

LIFO (Last-In, First-Out)

LIFO assumes that the most recently purchased inventory items are the first sold. This method is often used in industries with rising inventory prices, resulting in higher COGS and lower taxable income. Under LIFO, the ending inventory is valued based on the cost of the oldest items. Inflation reduces net income and ending inventory because COGS is inflated.

Weighted average cost method

The Weighted Average Cost method calculates COGS and ending inventory using the average cost of all inventory items available during the period. It smooths price fluctuations so COGS and unit costs remain consistent.

Specific identification method

The Specific Identification Method tracks and identifies the cost of each inventory item. It is often used for large, unique, or high-value items where it’s practical to track each item’s cost. The ending inventory and COGS are based on the actual cost of the items sold or remaining.

This valuation method matches cost and revenue. It is, therefore, ideal for businesses with expensive and distinguishable items, like car dealers.

The importance of inventory accuracy

Accurate inventory calculations are essential for an organization’s financial health and operational efficiency. They impact financial statements, ensure regulatory compliance, and support production and sales. With accurate data, forecasting demand is also easier.

Financial statements and accounting

Inventory affects the balance sheet and the income statement. Inaccurate inventory counts can lead to:

• Overstated or understated assets: Incorrect inventory records misrepresent the company’s financial position.
• Misleading profitability: Incorrectly calculated COGS affect gross profit, which could lead to flawed assumptions about the company’s profitability.
• Distorted financial ratios: Inventory accuracy affects key financial ratios. Incorrect ratios may incorrectly influence investor and stakeholder perceptions.

Phantom inventory

Phantom inventory is stock that is on the system but doesn’t physically exist. These issues can result from errors in recording, theft, damage, or misplacement. Efficient inventory management prevents phantom inventory through:

• Regular audits and cycle counts: Regular inventory checks ensure that physical inventory coincides with recorded stock.
• Automated systems: Automation software will reduce manual errors. Real-time tracking ensures that inventory records remain current.
• Training and procedures: Training employees on proper inventory handling reduces the risk of errors. Clear procedures ensure the use of standard operating methods.

Businesses must trust their inventory records for efficient operations and better decision-making.

Forecasting and demand planning

Forecasting and demand planning depends on accurate inventory data. Historical sales data is a predictor of future demand. Unless your data is current and precise, you can’t optimize stock levels to prevent stockouts or overstock situations. Accurate data offers the following demand forecasting benefits:

• Improved inventory turnover: Maintain optimal inventory levels, reduce excess stock, and free up capital with accurate forecasts.
• Enhanced customer satisfaction: Accurate forecasting ensures that products are available when customers need them. Backorders and lead times should drop.
• Cost savings: Accurate demand planning reduces the cost of holding too little or too much inventory, which includes storage, obsolescence, and lost sales.

Compliance and regulatory considerations

Various industries set standards and regulations for inventory reporting. This is crucial when dealing with perishable goods, pharmaceuticals, or high-value items. Primary considerations include:

• Tax reporting: Inventory valuation methods impact taxable income. Accurate records ensure precise tax calculations and tax compliance.
• Financial reporting standards: Adherence to Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) demands precise inventory accounting.
• Industry-specific regulations: Accurate inventory tracking ensures safety and traceability in the pharmaceutical and food industries.

Failure to comply with regulations and standards can result in legal and financial penalties.

How to maintain accurate ending inventory reporting

There are two main strategies used to ensure accurate inventory.

Regular Audits and Reconciliations

Regular audits and reconciliations involve physically counting inventory and comparing it with the system. This remains the most effective way to ensure accuracy.

Cycle Counting

Cycle counting involves regularly counting sections of the inventory throughout the year. Cycle counting takes the place of occasional full stock counts. It is less disruptive, allowing you to catch discrepancies early.

Prioritize counting high-value and high-turnover items. Inaccuracies in these areas can significantly impact financial statements.

Investigate the causes of discrepancies and take corrective actions. Adjust the inventory records after thorough investigation and reconciliation. All adjustments must be well-documented for audit trails and future reference.

Internal Controls

Install internal controls and segregate responsibilities between those who handle inventory and those who record it. This reduces the risk of fraud. Ensure regular training for employees involved in stock processing. Employees must understand the procedures and the importance of accurate reporting.

Inventory turnover ratio analysis

The inventory turnover ratio measures how efficiently the company manages its inventory by comparing the COGS with an average inventory. Regular analysis of this ratio helps identify inventory issues. Use the ratio to test whether your business is not holding excess or insufficient stock.

A high turnover ratio is generally positive, as inventory is quickly sold. However, it could also suggest that the company has insufficient inventory to meet demand and could run out of stock.

A low turnover ratio may indicate overstocking, which ties up capital and increases the risk of obsolescence. It suggests inventory management inefficiencies or a drop in sales.

Use turnover ratio analysis to set appropriate reorder levels and avoid excess inventory. Adjust purchasing and production schedules to closely match inventory levels with demand forecasts.

Stay ahead of ending inventory with Netstock

Accurately calculating ending inventory is vital for the financial health of your business. Ending inventory affects both the balance sheet and income statement. It is an asset on the balance sheet and directly affects COGS and profitability. Incorrectly calculated inventory has tax implications and could result in financial penalties. Regularly assess your inventory levels and use inventory management software to optimize your inventories.