Calculating ending inventory at the end of a financial year can be a challenge. It’s a time when you’re likely juggling between creating inventory reports and fulfilling end of year sales. This article simplifies those ending inventory challenges by looking at:
- The ending inventory formula
- Why ending inventory is one of the essential figures in your inventory reports
- Who is responsible for calculating ending inventory
- Beginning inventory
- Work in progress inventory
- How your inventory valuation method will impact the calculation
What is the ending inventory formula?
Ending Inventory is the value of the sellable inventory stock or product that remains at the end of a financial year. To calculate ending inventory you start by adding the beginning inventory and net purchases, then subtracting the cost of goods sold (COGS). So the ending inventory formula is:
Ending Inventory = Beginning Inventory + Net Purchases – COGS
How do you calculate ending inventory? An example
Knowing your ending inventory value helps you make informed decisions for the financial year ahead.
Imagine you are a stock manager for Jammin It Out, a company that makes jam. As the end of financial year approaches, you need to create an inventory report to understand the value of the assets you hold. You access balance sheets to calculate ending inventory:
To calculate ending inventory, you use the formula:
Ending inventory = Beginning Inventory + Net Purchases – COGS
Ending inventory = $250,000.00 + ($10,000.00 – $2,500.00) – $105,000.00
Ending inventory = $152,500.00
You now know that you are ending this year with $152,500.00 worth of inventory. In other words, you will start the next financial year with $152,500.00 worth of sugar, jars, finished jam, and so on.
Is there a faster way to calculate ending inventory?
In short, yes. Integrating your accounting software and inventory management software means that your apps will do the heavy lifting for you. All you have to do is maintain accurate stock information so that any information that flows through to your accounting software is correct.
Using the right software can help you accurately determine the value of your ending inventory much more quickly and with less stress.
Why is it important to calculate ending inventory?
It is important to calculate ending inventory because product businesses need to maintain accurate balance sheets and create consistent reports.
Overstating or understating ending inventory will impact COGS, gross margin and net income on the balance sheet. An incorrect inventory valuation causes two income statements to be wrong because the ending inventory carries over to the next financial year as the beginning inventory. Recording an accurate measure of inventory value will prevent discrepancies in future reports.
To accurately calculate ending inventory, you should also conduct a physical count of the remaining inventory stock on hand. A physical inventory stock count allows you to uncover any discrepancies between the actual stock and what you have in your inventory management system. For example, your system might show you have 1000 jam jars left in stock but due to breakages, you’re actually only left with 950 jars. If you didn’t conduct a stocktake, you’d be creating reports and balance sheets with incorrect data.
Who should calculate ending inventory?
An accountant or the person responsible for your company’s financial records should be calculating ending inventory. This process requires the accuracy of all data inputs at many levels of the business — from physical inventory stock counts to accurate sales and purchase data. Regardless of who actually calculates this figure, all managers and business owners should also have a basic understanding of these figures to help assess what future actions your business should take.
Beginning inventory and WIP inventory play an important role in your ending inventory.
The beginning inventory for the current financial year is the ending inventory amount for the previous financial year. To calculate beginning inventory you start by adding COGS and ending inventory, then subtracting net purchases. So, the beginning inventory formula is:
Beginning Inventory = COGS + Ending Inventory – Net Purchases
Why is it important to know beginning inventory?
The beginning inventory figure represents all the inventory stock a business can put towards generating revenue. Businesses can use the beginning inventory formula to understand the value of their inventory at the start of a new financial year.
You can track changes to any beginning inventory by comparing this with the previous period. Any changes usually signal a shift in the business, for example, decreasing beginning inventory could be a result of an increase in sales during the period, or it could be down to a supply chain or inventory management process issue. Increased beginning inventory could also be due to a business increasing stock before a busy holiday season – or it could signal a downward trend in sales.
Ending work in progress (WIP) inventory
Work in process (WIP) is inventory that’s partially completed but needs more processing before it is finished. On a company’s balance sheet, it is also listed as a current asset. To calculate ending WIP inventory, you need to use the formula:
Ending WIP Inventory = Beginning WIP inventory + Manufacturing Costs – Cost of goods manufactured
This formula only gives an approximate ending WIP inventory because factors such as spoilage and incorrect record-keeping can cause discrepancies between the calculated final figure and the cost of actual WIP inventory on hand.
Why track ending WIP inventory?
Businesses need to know ending WIP inventory as part of the period-end closing process. It can also indicate how well the manufacturing process is going. Values that are too high can signal slowdowns in the manufacturing process. And since WIP inventory items are not finished goods, they cannot be sold. This represents capital tied up in stock and lost revenue opportunities.
Your inventory valuation method will impact ending inventory
There are three ways to determine the value of your inventory — FIFO, LIFO and weighted average cost. The method chosen influences your cost of goods sold and it is important to stick to one method because it will impact everything from budgeting to reordering inventory.
Here’s how each method will change the value of your ending inventory.
If you’re using FIFO to calculate ending inventory
Most businesses use the first-in first-out (FIFO) method of allocating costs to inventory, which assumes the inventory stock that you purchased first is sold first.
With FIFO, your inventory stock is valued at the most current price and can better reflect ending inventory and actual marketplace costs. The method is not fool-proof, and the actual flow of inventory may not align to this first-in, first-out pattern.
Business owners may choose FIFO in periods of high prices or inflation, as it produces a higher value of ending inventory than its counterpart method last-in, first-out (LIFO). Most companies, especially those stocking fresh goods — like a seafood distributor for example — will use FIFO.
If you’re using LIFO to calculate ending inventory
The LIFO method assumes that the last item of inventory stock purchased is the first one sold. A business will use LIFO on the basis that the cost of inventory naturally increases over time, where pricing inflation is the norm. Businesses like tobacco stores, liquor stores, and pharmacies typically use the LIFO method because the cost of their inventory typically rises over time.
The effect of this method is that the cost of the most recently acquired inventory stock will be higher than the cost of inventory purchased earlier. So, the ending inventory balance will be valued at earlier costs, and most recent costs will appear in the COGS.
Accountants may encourage businesses to use LIFO during times of decreasing prices.
If you’re using weighted average cost to calculate ending inventory
Another method business owners and managers use to account for inventory on the balance sheet is the average weighted method. To use this method, simply divide the cost of goods the business has available for sale by the number of units for sale. This calculation will give you the weighted-average cost per unit.
Average weighted COGS is a simple way to value ending inventory, and best to use when all products sold are identical. Unleashed Software uses the average weighted cost method.
Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.