Understanding how to calculate the amount of ending inventory and assign its monetary value is essential in accurately evaluating the financial health of a business. Inventory is one of the most valuable current assets that a company has. Proper inventory management is imperative in keeping track of all the supplies and satisfying customer demand appropriately. The process of inventory management is a delicate balancing act, especially with complex supply chains. However, in the end, it provides the benefits of resource efficiency, improved production processes, and better sales.
Calculating the ending inventory helps provide a transparent picture of a company’s current assets, gross profits, and available stock. An incorrect calculation of this metric may lead to misleading income statements and balance sheets, which can have detrimental consequences for any business.
The amount of ending inventory is used not only for tax purposes but also for estimating the value of a company. It is especially significant if a company is searching for investors. The ending inventory can also help examine if stocks and sales match and shed light on unexpected production costs.
If you want to become an inventory management whiz, you have come to the right place. In this article, you will learn how to calculate the ending inventory, the importance of this metric, and the main valuation methods used to value stock.
To put it in a nutshell, ending inventory is the amount of value of the sellable products company has left in stock at the end of an accounting period. It can be calculated using the following formula:
Ending Inventory = Beginning Inventory + Net Purchases -COGS
- Beginning Inventory= the amount/value of inventory available at the beginning of the accounting period. It is equal to the ending inventory amount of the previous computing period.
- Net purchases = any additional items that a company may have purchased and added to their stock during the period of observation.
- COGS = The total amount paid by the business as costs that goes into producing / selling the final product.
As can be seen, the ending inventory is computed using the metric COGS (Cost of Goods Sold). This is a key aspect, as the equation can be rewritten in the following way:
COGS = Beginning Inventory + Net Purchases – Ending Inventory
This means that the ending inventory is used to derive the cost of goods sold COGS is a very important metric for any business. It basically, calculates the costs of all the materials and labor that go into producing and later selling a product.
There is another reason why COGS is so important. Accountants can use different methods for inventory valuation. Simply put, there are several ways in which the value of COGS can be determined, which will therefore affect the final value of the ending inventory. To be precise, the amount of physical inventory at the end of the accounting period will remain the same. However, the portion of the total value assigned to either COGS or Ending Inventory will vary (This will become clearer with the example given later on). Once the method is chosen, the company should stick with it, otherwise, the financial statements will become disorganized, and it will become difficult to evaluate progress or make comparisons.
Methods of Inventory Valuation
FIFO– First-in, First-out method assumes that the oldest inventory items (those purchased/produced first) will be sold first. This means that the ending inventory reflects the costs of items that have been acquired most recently. This means that the costs of the older purchases will be included in COGS. This is a popular method used by companies with perishable goods.
LIFO– Last-in, First-out method is one of the most common ones. In this method, the assumption is that the most recently purchased/produced items will be sold first. This means the ending Inventory reflects the costs of the oldest purchases, while COGS for the most recent ones.
WAC- Weighted Average Costs is a method where costs are assigned averaged over the items, so it is not important which item is sold first/last.
The method used for inventory valuation is imperative. Both the value of the ending inventory and COGS are later used to complete income statement items (Gross profit, Net income) as well as balance sheet items (Working capital, total assets, equity).
This time we will use one scenario to showcase the differences between the three methods mentioned above.
“The Reading Record” is a popular bookstore in the neighborhood. It is nearing the end of the accounting period, so the manager needs to calculate and record the ending inventory to plan for the next year and to fill in all the other financial statements. They look over the records from the last quarter. The records say that throughout the last quarter (Months October, November, and December) the bookstore made 620 sales. They started October with 230 books in the store, each purchased on average for 10$. In the following month, they had to refill their storage a couple of times.
The amount of inventory as well as unit cost is given in the table below. Calculate the ending inventory value using FIFO, LIFO, and WAC methods.
|Month||Number of units||Cost per unit ($)||Total Costs|
In order to calculate the ending inventory, we need to calculate COGS using different methods.
Calculation 1: FIFO
As we remember FIFO believes that the oldest purchased inventory will be sold first. Since we know that 620 items were sold in total, the calculations will be as follows:
COGS = (230 x 10) + (170 x 12) + (200 x 14) + (20 x 15) = $ 7440
As can be seen from December’s purchases we only take the first 20 items. The last 130 will not be sold and will be included in the ending inventory.
Net purchases in this period are equal to the sum of the Number of units * cost per unit for each month.
Net Purchases = 2040 + 2800 + 2250 = $ 7090
Ending Inventory = 2300 + 7090 – 7440 = $ 1950
We could also simply calculate this by multiplying the remaining inventory in December 130 units by the cost per unit – $15.
Calculation 2: LIFO
For the LIFO method, the cost of goods sold will include the costs of the most recent items purchased.
COGS = (150 x 15) + (200 x 14) + (170 x 12) + (20 x 10) = $ 7290
The first 210 items that were part of the beginning inventory will not be counted as part of COGS and will be included in the ending inventory.
Ending Inventory = 2300 + 7090 – 7290 = $ 2100
Calculation 3: WAC
For Weighted average Costs, the company assigns the same weighted costs to every item no matter if it is sold or not. To calculate WAC, we need to divide the total purchase costs by the total number of inventory items purchased.
= $ 12.52
Considering this since 620 items were sold and 130 remained in the ending inventory:
COGS = 620 x 12.52 = $ 7762.4
Ending Inventory = 130 x 12.52 = $ 1627.6
As we can see in all three cases the total sum value of COGS and Ending inventory is the same $9390.
The most accurate measure of the ending inventory can be derived if a physical count is conducted. However, this is very impractical and time-consuming, especially for larger businesses. Larger companies usually use advanced inventory management software or other technologies to help them keep an accurate count of inventory. If there is no possible way to determine an accurate count of stock at hand, there are other available ways to estimate ending inventory: Gross profit and the retail method. Both of these methods are used to derive very rough estimates for the Ending inventory.
Gross profit method creates expected gross profit margins based on the past numbers to determine COGS. COGS is calculated from multiplying net sales in the time period by (1-gross profit margin). This gives an estimate of COGS which can be used to calculate the Ending inventory. In the same way, the retail method calculates COGS through multiplying net sales by cost-to-retail ratio.
COGS and Ending Inventory are not the same or similar. Ending Inventory is recorded on the balance sheet. On the other hand, COGS is recorded on the income statement.
Ending inventory can be of three types.
- Raw materials– all the natural resources and materials used in the primary production process.
- Work-in-Process Inventory– materials that are in the process of production being converted into complete goods.
- Finished goods– completed products ready to be sold.
Inventory shrinkage is when a company’s calculated ending inventory and the actual amount in storage do not match. The loss of inventory can be due to a multitude of reasons including theft, accounting errors, spoilage, etc.