Ending InventoryDefined along with formula and more
When you sell goods, whether they are ready-made or made-to-order, you’ll have to properly manage your inventory.
Ideally, you don’t want to waste any of your inventory.
This is especially tricky when the goods that you’re selling have an expiration date to them.
But whatever type of goods that you’re selling, you’d probably end up having some of them left by the end of the period.
We typically refer to these leftover goods as ending inventory.
Other than goods that available for sale, inventory may also include raw materials or goods that are still work-in-progress.
Now, whether they’re available for sale, work in progress, or raw materials, it’s always important to account for your ending inventory.
By knowing the value of your ending inventory, you can better manage the flow of goods and materials for the upcoming period.
Too much ending inventory?
You might have to slow down the production of goods (for manufacturers), order fewer stocks (for retailers and wholesalers), or boost your sales so that inventory goes out faster.
Accounting for your ending inventory is also important in the preparation of financial statements, particularly the balance sheet.
Typically, the inventory figure that appears on the end-year financial statements represents the value of that year’s ending inventory.
It can ultimately affect the business’s valuation as well as some of its financial ratios.
In this article, we will be talking about ending inventory.
What is its importance to a business?
How does one account for ending inventory?
What are the methods that businesses use to value their inventory (including ending inventory)?
Can ending inventory affect a business’s profitability?
How about its tax liability?
We’ll try to answer these questions as we go along with the article.
What is Ending Inventory?
In accounting, ending inventory refers to the value of goods (that are available for sale), materials, and work-in-progress left and still held by the business at the end of the accounting period.
We can also refer to it as closing inventory.
The value (dollar amount) of a business’s ending inventory will depend on the inventory valuation method that it uses.
Even if the business has the same physical number of units in ending inventory, the value of ending inventory might be different depending on the inventory valuation method that the business uses.
What comprises the ending inventory will depend on whether or not the business manufactures its own goods.
For a business that orders/purchases the goods that it sells (e.g. retailers and suppliers), its ending inventory will only include the leftover merchandise at the end of the accounting period.
For example, let’s say that you own a business that sells ready-to-wear (RTW) clothing.
At the end of the year or accounting period, whatever RTW clothing is on display (that’s for sale) and those that are in your business’s stockroom will be its ending inventory.
It’s important to note that in this case, ending inventory should include goods that are available for sale.
If a product is only for display purposes and is not for sale, it should not be included in the ending inventory.
For a business that manufactures the goods that it sells, its ending inventory will include any leftovers of the following at the end of the year or accounting period:
- raw materials
- work-in-progress; and
- finished goods (or goods available for sale).
To better track them, it’s recommended to maintain a separate account for each of them (e.g. raw materials – ending inventory, WIP – ending inventory, finished goods – ending inventory, etc.).
Calculating Ending Inventory
Calculating ending inventory is fairly simple. We only need three variables: the beginning inventory, net purchases, and cost of goods sold.
The formula for calculating ending inventory is as follows:
Ending Inventory = Beginning Inventory + Net Purchases – Cost of Goods Sold
Beginning inventory is the value of inventory at the beginning of the accounting period.
It’s usually the same value as the ending inventory of the previous accounting period.
If the business doesn’t have any inventory at the beginning of the year, the value of the beginning inventory should be zero.
Net purchases refer to all the merchandise that the business ordered or purchased during the accounting period.
If there are any purchase discounts, returns, and/or allowances, they should be deducted from the gross value of purchases.
The cost of goods sold refers to the value of goods that the business sold within the accounting period.
Just like with ending inventory, its value will depend on the inventory valuation method that the business uses.
For example, let’s say we have the following data:
- Beginning inventory – $21,300
- Purchases – $128,000
- Purchase returns – $8,000
- Cost of goods sold – $121,800
With this data, we can calculate the ending inventory.
But first, we have to calculate the net purchases:
Net Purchases = Purchases – Purchase Returns, Discounts, and Allowances
= $128,000 – $8,000
With that, we can proceed with the calculation of the ending inventory:
Ending Inventory = Beginning Inventory + Net Purchases – Cost of Goods Sold
= $21,300 + $120,000 – $121,800
As per our calculation, the ending inventory has a value of $19,500.
Calculating Ending Inventory (for those that manufacture the goods that they sell)
The calculation of ending inventory for manufacturers is less simple because they need to account for at least three types of inventory (raw materials, work in progress, and finished goods).
Each type of ending inventory requires a different calculation.
The calculation of the finished goods ending inventory is similar to that of a retailer/wholesaler.
However, since a manufacturer doesn’t directly purchase the goods that it sells, the formula will not use purchase. Rather, it will use the cost of goods manufactured (COGM). Here’s what the formula looks like:
Ending Inventory (Finished Goods) = Beginning Inventory (Finished Goods) + Cost of Goods Manufactured – Cost of Goods Sold
The cost of goods manufactured refers to the value of work in progress that has been converted to finished goods within the year. It’s also used in calculating the value of work in progress (WIP) ending inventory, as shown in the following formula:
Ending Inventory (Worked in Progress) = Beginning Inventory (Worked in Progress) + Manufacturing Costs – Cost of Goods Manufactured
Manufacturing costs refer to the total cost of raw materials used, direct labor, and manufacturing overhead.
The cost of raw materials used is also used to calculate the value of the raw materials ending inventory:
Ending Inventory (Raw Materials) = Beginning Inventory (Raw Materials) + Purchases – Cost of Raw Materials Used
Inventory Valuation Methods (a.k.a. Inventory Costing Methods)
Depending on the inventory valuation method that the business uses, the dollar value of a business’s ending inventory will differ.
For example, let’s say that a business has 10 physical units in ending inventory.
Under one valuation method, this ending inventory costs $1,200.
However, under another inventory method, it costs $1,150.
Each inventory valuation method has its own set of advantages and disadvantages.
Here are some of the better-known inventory valuation methods:
- FIFO (First In, First Out)
- LIFO (Last In, First Out)
- WAC (Weighted Average Costing)
- Specific Identification
(We will only be touching a bit on each inventory valuation method.
For a more in-depth discussion of these methods, click here).
FIFO (First In, First Out)
Under the FIFO method, it’s assumed that the business sells its oldest goods first before selling the new ones.
The value of goods changes over time after all, so it’s impractical to assume that the value of the oldest goods will be the same as the newest ones.
This results in having the value of the ending inventory equal to the cost of the newest goods.
LIFO (Last In, First Out)
The LIFO method is the opposite of the FIFO method.
Rather than assuming that the oldest goods are sold first, LIFO assumes that the newest goods are sold first instead.
While it’s as simple as the FIFO method, the LIFO method is rarely used.
There’s rarely a good reason to sell the newest inventory before selling the oldest one.
It’s more logical to sell your oldest stocks first.
WAC (Weighted Average Costing)
The WAC method averages the price of all inventory to determine the cost of goods sold (and consequently, the ending inventory).
It does this by dividing the cost of goods produced or purchased by the number of units available for sale.
By averaging the cost of inventory, the effect of fluctuating prices is lessened.
Under the specific identification method, each unit is assigned its own cost.
This inventory valuation method is most suitable for businesses that have goods that are high value and identically different from each other (e.g. paintings, luxury watches, etc.)
It requires more time and effort and is probably not worth using if your inventory is heterogenous and has a very high volume.