What is ending inventory?
Ending inventory is a term used to describe the monetary value of a product still up for sale at the end of an accounting period. This number is required to determine the cost of goods sold (COGS) and the ending inventory balance. A company’s ending inventory should be included on its balance sheet and is especially important when reporting financial information. Smaller companies are sometimes able to calculate their ending inventory by simply counting the product leftover at the end of an accounting period. However, most companies use a formula to determine the total value of the product left over.
Why is ending inventory important?
Match inventory recorded with actual inventory
You’ll want to double-check that the values on your inventory balance sheet match what’s in your warehouse right now. Knowing your ending inventory ensures that the inventory you’ve recorded corresponds to the real stock you have on hand. Inventory shrinkage could be caused by accounting errors, theft, or a variety of other concerns if your inventory levels are lower than they should be.
Calculates the net income
Similarly, you’ll want to know the exact income statement, or how much money you’re making from what you’re selling. Once you’ve calculated the ending inventory, you’ll be able to tell whether your actual inventory matches the inventory that was recorded. If the numbers don’t match up, this could be a sign that you’re paying too much for the initial purchase of goods based on current market value, or that it’s time to rethink your pricing strategy.
Ensures accuracy for future reports
Remember how ending inventory is calculated from beginning inventory? It goes the other way too. A given accounting period’s beginning inventory is calculated from the previous period’s ending inventory. The beginning balance is calculated from the previous reporting period’s ending balance. Therefore, it’s crucial that the correct ending inventory is calculated.
What is the formula to calculate ending inventory?
Here is the basic formula you can use to calculate a company’s ending inventory:
Ending Inventory = Beginning Inventory + Net Purchases – COGS
In this formula, your beginning inventory is the dollar amount of product the company has at the onset of the accounting period. The net purchases portion of this formula is the cost of any new product or inventory items bought during the accounting period. The cost of goods sold is the amount of money it costs to produce goods that are part of the company’s inventory.
The simplest way to calculate ending inventory is to do a physical inventory count. But most of the time it doesn’t make sense to do a physical count, especially if you have a large amount of inventory to keep track of. Fortunately, there are better ways to calculate ending inventory that provides more accuracy and is more efficient.
FIFO (First in First Out) method
FIFO (First in First Out) is an inventory tracking protocol that assumes that the first units of inventory purchased or manufactured are the first to be sold. Using FIFO to calculate ending inventory means that the cost of purchasing the oldest inventory (or First in) will be allocated first to COGS, and the cost of the newest inventory will be allocated to ending inventory. This means that if the cost of purchasing or manufacturing your inventory increases since your oldest inventory was purchased, your COGS will be lower for the first items sold (First Out).
For example, you begin an accounting period with 100 units of a certain SKU purchased (or manufactured) at $5 per unit. Then later in the accounting period, you place a replenishment order for 100 more units at $7 per unit. During the entire accounting period, you sell 125 units. To calculate your COGS, you’ll use the cost of the first 100 units you ordered (5 x 100 = $500) plus the 25 units sold from your replenishment order (7 x 25 = $175), so your total COGS for that accounting period will be $675.
Using the ending inventory formula with this COGS value would give you the following ending inventory:
$500 (beginning inventory) + $700 (net purchases) – $675 (COGS) = $525 (ending inventory)
LIFO (Last in First Out) method
LIFO (Last in First Out) is an inventory tracking protocol that assumes that the inventory purchased or manufactured most recently was sold first. Using LIFO to calculate ending inventory means that older inventory is allocated to ending inventory, while newer inventory (Last in) is allocated first to COGS. This means that if the cost of purchasing or manufacturing your inventory increases since your oldest inventory was purchased, your COGS will be higher for the first items sold (First Out).
Let’s assume again that you have 100 units of a single SKU purchased (or manufactured) at $5 per unit. Then later in the accounting period, you place a replenishment order for 100 more units at $7 per unit. Then, throughout the entire accounting period, you sell 125 units. To calculate your COGS using the LIFO method, you would use the cost of the last 100 units you ordered (7 x 100 = $700) plus the 25 units you sold from your original order (5 x 25 = $125), so your total COGS for the accounting period would be $825.
Using the ending inventory formula with this COGS value would give you the following ending inventory:
$500 (beginning inventory) + $700 (net purchases) – $875 (COGS) = $325 (ending inventory)
WAC (weighted average cost) method
WAC (weighted average cost) averages your COGS based on the cost of all inventory purchased during the accounting period divided by the total number of units on-hand. Using the WAC method to calculate ending inventory means that all units are given the same (weighted) value.
We’ll assume again that you have 100 units of an SKU purchased (or manufactured) at $5 per unit. You then place a replenishment order for 100 units at $7 per unit. Throughout the accounting period, you sell a total of 125 units. Using the WAC method, you would add the total cost of both orders (500 + 700 = $1,200), then divide that by the total number of units (1200 / 200 = $6 per SKU) Your COGS would be calculated by multiplying your weighted average cost of $6 by the number of units you sold (6 x 125) for a total of $750.
Using the ending inventory formula with this COGS value would give you the following ending inventory:
$500 (beginning inventory) + $700 (net purchases) – $750 (COGS) = $450 (ending inventory)
Final Thoughts
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.
