If you’re a business that sells goods, then odds are you’re at least somewhat familiar with the term “ending inventory.”
The ending inventory formula is a valuable tool to help companies better understand the total value of products they still have for sale at the end of an accounting period. Understanding what your ending inventory is will help you not only sell more product, but also help you forecast marketing and sales for the upcoming month, quarter, or year.
In today’s article, we’ll talk more about what ending inventory is and how the formula can help your business.
Ready to learn more?
What is Ending Inventory?
As we hinted at in the intro, ending inventory describes the financial value of inventory you still have for sale at the end of an accounting period. You’ll need to know your ending inventory numbers to accurately calculate the cost of goods sold (COGS) as well as your ending inventory balance.
The number of items in inventory at the end of a period is constant based on the count, but there are different methods to determine the valuation of that inventory. We’ll break down all of the various methods you can use later in this article.
One thing to keep in mind is that ending inventory is a key figure when companies seek financing and should be included on your balance sheet.
For smaller companies, it’s possible to manually track your inventory numbers by hand counting your stock. However, bigger companies generally use one of a number of different formulas to determine the value of their remaining inventory.
What is the Formula to Calculate Ending Inventory?
Now that we have a working definition for ending inventory, let’s talk about the formula you’ll use to calculate your amounts at the end of each accounting period.
Here’s the formula:Beginning inventory + net purchases – COGS = ending inventory
As you can see, you don’t exactly need a degree in math to make this formula work for you.
A common reason businesses cite for not doing better inventory management is that it’s too complicated. And while inventory management can be complex, the math involved in figuring out most of these numbers is simple. It becomes even easier when you utilize inventory management software.
At any rate, let’s break down this formula so you can get a better understanding of each of the parts involved.
In the first part of the equation, beginning inventory is the dollar value of the product your business has on hand at the start of the accounting period.
Net purchases refers to all the new products or inventory added to the mix during the accounting period.
Cost of goods sold refers to the amount you spend to produce the products and goods that are part of your inventory.
Now that we know what each of the components are, let’s talk about the most common ways of calculating ending inventory.
1. First In, First Out (FIFO)
The First In, First Out method of calculating ending inventory works on the idea that the oldest items in your inventory will be the first to be sold. This means, as the name suggests, that the first inventory items you receive will be the first inventory you use to make products or fulfill orders.
Using this method, the current cost is the same as the cost of the most recent item sold for accounting purposes.
The idea behind FIFO is that it fits the way the vast majority of companies handle their inventory. Older items are always sold first in order to keep a steady supply of newer product in inventory, ready for sale.
The one potential downside of FIFO is that it can be skewed in times when inflation is high. In these situations, your ending inventory value can be inflated.2. Last In, First Out (LIFO)
Our second popular method for tracking ending inventory is Last In, First Out.
In this approach, the newest items in your inventory are sold first, leaving the older items as in stock. Naturally, this approach doesn’t work for every business, but here’s the logic behind using it.
In the Last In, First Out methodology, the assumption is that the cost of the last item purchased is the same as that of the first item sold. Oil companies, supermarkets, and other businesses that experience frequent price fluctuations in their inventory costs tend to prefer the Last In, First Out method.
To visualize this, imagine a company that sells sand. The company has huge mountains of sand at their location – and as new sand comes in, it’s dumped on top of an existing sand pile.
Then, when a purchase is made, the sand sold isn’t taken from the bottom of the sand mountain, but instead from the top – so the newest sand added to the pile is also the first sand sold.
When inventory costs are growing, LIFO allows a business to show the highest cost of goods sold and the lowest gross profit. This is often desirable if you’re trying to get a lower tax rate.
3. Weighted Average Cost Method (WAC)
In the weighted average cost method, you’ll assign a value to the ending inventory and your cost of goods sold based on the total number of goods produced or purchased in an accounting period. You’ll then divide this by the total number of products produced or purchased.
The advantage weighted average cost provides over First In, First Out and Last In, Last Out is that it assigns the same value to each item you’ve purchased. This allows you to average out the costs over the period instead of relying on the oldest prices in the First In, First Out method or the latest prices in the Last In, First Out method.
As such, you can eliminate some of the potentially wild fluctuations you might experience in some accounting periods when using those methods.
Like everything, there are pros and cons to the weighted average cost method. These are some of the things you should be aware of before committing to using this method.
- Easier to calculate costs with a high volume of goods
- Saves time when determining how to set prices
- Makes manipulating accounting figures more difficult
- Provides a more accurate snapshot of how business is doing
- If prices have gone up during an accounting period, you may sell items at a loss
- Calculations are more difficult when you have a wide range of products with slight variations.
It should be noted that weighted average cost is an accepted method of tracking inventory under both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).4. Gross Profit
Another way to determine your ending inventory amount is by using a gross profit calculation.
In the gross profit method of estimating ending inventory, you’ll need to actually know either the gross profit percentage or the gross margin ratio.
If you’re unsure how to figure out those numbers, here’s a quick example.
If your business buys items for $80 and sells it for $100, that’s a gross profit of $20. The gross margin ratio is 20%.
So, if a company has $100,000 in sales, we can assume the cost of the items purchased is $80,000 (which is 80% of the sales amount like in the individual example – or just subtract the $20,000 gross profit amount).
With that information, we can then use these steps to figure out our ending inventory:
- Add cost of beginning inventory and cost of purchases to get the cost of goods available for sale.
- Calculate the estimated cost of goods sold by multiplying (1 – expected gross profit percentage) by sales in the period to get an estimated cost of goods sold.
- Subtract the estimated cost of goods sold from the cost of goods available in the first step to get your ending inventory.
It should be noted that while the numbers you get here can be useful, the gross profit method is not acceptable for determining year-end inventory totals or for audited financial documents.
5. Retail Method
And finally, we come to our last ending inventory approach: the retail method.
As the name suggests, this one is commonly used by retailers and uses a proportional relation between retail price and costs in earlier periods.
Here’s how it breaks down:
- Determine cost to retail percentage (Cost-To-Retail Percentage = Cost / Retail price)
- Determine cost of goods available for sale (Cost of Good Available for Sale = Cost of beginning inventory + Cost of purchases
- Determine the cost of sales during the period you’re tracking (Cost of Sales = Sales x Cost-To-Retail Percentage
With all that groundwork out of the way, you can finally calculate the ending inventory with this formula:
Ending Inventory = Cost of goods available for sale – Cost of sales during the period
Here are the pros and cons of this approach:
Doesn’t require a physical inventory
Not particularly accurate
To expand on the con of this method, the issue is that the retail method is only accurate if all pricing is the same and all pricing changes occur at the same rate. As anyone working in retail knows, this is not something that’s likely to occur.
Markdowns, sales, product damages, depreciation, and theft can all have a profound impact with this method.
As you can see, when it comes to determining your ending inventory, you’ve got options.
All of the methods outlined in this article are useful and can help you determine your ending inventory amounts. However, each has its own unique set of advantages and disadvantages as well.
The good news is you are now armed with enough information about each approach to start determining which system will best serve your business.
Remember, there’s no right or wrong choice here – only the choice that’s right for you.
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