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 your ending inventory will help you sell more products and help you forecast marketing and sales for the upcoming month, quarter, or year.
The new purchases are added to the ending inventory to calculate the ending inventory, minus the cost of goods sold. This provides the final value of the inventory at the end of the accounting period.
The ending inventory is based on the market value or the lowest value of the business’s goods.
What this article covers:
- What is the ending inventory?
- Why is it important to calculate ending inventory?
- What is the ending inventory formula?
- Ways of calculating ending inventory
What is the ending inventory?
Ending inventory refers to the sellable inventory you have leftover at the end of an accounting period. When a given accounting period ends, you take your beginning inventory, add net purchases, and subtract the cost of goods sold (COGS) to find your ending inventory’s value. For a balance sheet to be complete, you’ll need to claim all inventory as an asset. Knowing your ending inventory value will impact your balance sheets and your taxes, so it’s important to calculate your inventory value correctly.
Why is it important to calculate ending inventory?
Calculating ending inventory is important for a handful of reasons, including:
- Find the cost of goods sold (COGS): Finding COGS lets you find your gross profit, margins and identify ways to improve inventory ordering.
- Match recorded inventory to actual inventory: This lets you match your inventory balance sheet with your stock list so that you can identify inventory shrinkage due to loss, theft, spoilage, etc.
- Calculate net income: Helps you determine what you make on what you’re selling. A mismatch on inventory can suggest that you’re overpaying for inventory, or you might want to adjust your pricing strategy.
- Determine net income for tax purposes: A complete balance sheet claims all inventory as an asset for tax savings.
Companies calculate ending inventory at the end of every accounting period. This is because ending inventory for this accounting period is the beginning inventory for the next accounting period. And so, calculating ending inventory keeps your ordering on track and your company on a budget.
What is the ending inventory formula?
The ending inventory formula is:
Beginning Inventory + Purchases – Sales = Ending Inventory.
Beginning inventory plus purchases is referred to as the cost of goods available for sale. The goods are either sold or remain in ending inventory. When items are sold, the current cost is moved from inventory into the cost of goods sold (COGS) account.
Inventory purchases increase the balance, while sales decrease the amount of inventory on hand. You can change any of the variables in the formula to assess the impact on your business.
The formula helps managers to control spending and meet customer demand. Your goal is to buy enough inventory to fill customer orders, but not so much that you deplete your bank account. If you have too much cash tied up in inventory, you may not have enough cash to operate the business.
Ways of calculating ending inventory:
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 products 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.
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.
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 potentially wild fluctuations you might experience in some accounting periods when using those methods.
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