Midsize business

What is the ending inventory formula and how can you use it?

The total value of your inventory may be the largest dollar amount on the balance sheet and a significant use of your available cash. You can use the ending inventory formula to manage the total inventory cost and utilize your resources effectively.

Businesses should also choose an inventory valuation method to determine the cost of purchases and compute sales profits. Finally, ending inventory is used to perform an analysis of your financial statements.

What is ending inventory?

Inventory is defined as items purchased for resale to customers, and inventory includes the cost of the goods, plus additional spending. Costs incurred to prepare the goods for sale are included in inventory, including shipping costs and costs incurred to display the items to customers. When a manufacturer finishes producing goods, they are also recorded as inventory.

Beginning inventory represents the items on hand at the beginning of an accounting period (month or year), and ending inventory is the balance at the end of the period.

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 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.

How to use the ending inventory formula

To use the formula, decide on a dollar amount of ending inventory that you can keep on hand at month-end. The amount might be based on a percentage of monthly sales.

If you get customer orders during the first few days of the next month, you’ll be able to fill the orders. Estimate your sales for the month, and use the ending inventory formula to plan your purchases

Assume, for example, that a sporting goods retailer has a beginning inventory of baseball bats totaling 7,000 units, and the store forecasts 20,000 bat sales for the month. If the retailer wants 2,000 bats (10% of expected sales) in ending inventory, the number of bats purchased should be:

20,000 projected sales + 2,000 ending inventory – 7,000 beginning inventory = 15,000 purchased

Net purchases are the items purchased after subtracting returns or damaged goods. Use net purchases in the ending inventory formula.

The inventory example above computes ending inventory in units. Another factor is the dollar value placed on each unit of ending inventory. Your business can use several valuation methods.

Ending inventory methods and examples

The ending inventory balance in the balance sheet is the number of units in inventory, multiplied by each unit’s cost. Here are three common methods used to calculate the cost of inventory.

First-in, first-out (FIFO) method

The first in, first out (FIFO) method assumes that the oldest items in inventory are sold first.

Let’s assume that a retailer sells home furnishings, including several product lines of candles. The current inventory of Seaside Candles includes these purchases:

  • 500 candles purchased on Dec 1st for $10 each
  • 250 candles purchased on Dec 15th for $12 each
  • 750 candles purchased on Dec 20th for $13.50 each

If Sunshine sells a total of 400 candles on December 25th, the FIFO method values the candles sold at $10 each.

Most companies use the FIFO method to value items sold out of inventory. Some firms, however, use last in, first out (LIFO) method.

Last-in, first out (LIFO) method

To understand the LIFO method, think about buying milk at the grocery store.

The oldest gallons of milk are pushed to the front of the refrigerator so that you’re more likely to buy the older product before it expires. To get to the newer milk, you have to reach behind the old products. Getting to the newer milk is the LIFO method.

LIFO assumes that the newest units are sold first. If Sunshine uses the LIFO method, the 400 candles sold on December 25th are valued at $13.50 each.

The weighted average cost is the easiest method used for inventory costing.

Weighted average cost method

To compute weighted average cost, you add the total dollar amount of purchases and divide the balance by the total number of units purchased.

Here is the total dollar amount of the three purchases of Seaside Candles:

  • 500 candles at $10 each = $5,000
  • 250 candles at $12 each = $3,000
  • 750 candles at $13.50 each = $10,125

The retailer spent $18,125 to purchase 1,500 candles, and the average cost per candle is $12.08. If the business uses the weighted average cost, $12.08 is assigned as the cost of each candle sold.

Impact on profit

The inventory cost method has an impact on profit in the income statement. To illustrate, let’s assume that Seaside Candles have a market value of $20 per unit. The 400 candles sold on December 25th generate a different amount of profit, depending on the inventory valuation method you choose:

  • FIFO method profit: $10 per unit ($20 price less $10 cost)
  • LIFO method profit: $6.50 per unit ($20 price less $13.50 cost)
  • Weighted average method profit: $7.92 per unit ($20 price less $12.08 cost)

It’s important to realize, however, that the total profit generated on the sale of 1,500 candles is the same, regardless of the inventory cost method chosen. The total value of goods is $30,000 (1,500 units at $20 sale price), the total cost of goods sold is $18,125, and the profit is $11,875.

The inventory cost method only changes the timing of when profit is recognized. Consider these timing relationships:

  • FIFO assumes that the cheaper units are sold first, and the more expensive units are sold later. This valuation method records more profit in the early periods, and less profit when the remainder of inventory is sold in later periods.
  • LIFO is the reverse: more expensive units are sold first, and cheaper units are sold later. As a result, LIFO records less profit in early periods, and more profit in later periods.
  • Finally, the weighted average method recognizes costs evenly as units are sold, and profit is posted evenly from one period to the next.

Accounting principles require that you consistently use the same method so that your financial results are consistent from year to year. Fortunately, accounting software can track the costs and post the correct amounts automatically.

Advantages of using the ending inventory formula

One advantage of using the formula is the ability to change any of the variables and assess the impact. If your sales estimate increases, for example, you can plug the new sales assumption into the formula and review the impact on inventory.

Performing analysis

You can use the ending inventory balances in past months to perform an inventory analysis and to compare your results to other businesses in your industry.

One great metric is the inventory turnover ratio, which is calculated as cost of goods sold divided by average inventory. Average inventory is simply (beginning inventory plus ending inventory) divided by two. Use the ending inventory balances to compute average inventory for a fiscal quarter or a year.

If you can increase sales and minimize inventory levels, the ratio will increase. Increasing the ratio means that you are making more sales without having to increase the inventory balance at the same rate.

Counting inventory

Ending inventory is a tool you can use to increase the accuracy of a physical count of inventory. A year-end inventory count confirms that the accounting records match the physical inventory items on hand at the end of an accounting period.

If a CPA firm is conducting an audit of the December 31st financial statements, the accountants will count the physical inventory on the last day of the calendar year. If the auditor cannot access inventory on 12/31, the firm will count inventory as close to the end of the year as possible.

These procedures ensure that the December 31st inventory count is accurate:

  • Accounting listing: The company accountant prints a detailed listing of the firm’s inventory on December 31st and distributes the listing to each person who is counting inventory.
  • Inventory access: Company management notifies the warehouse staff that no inventory should be received after 5 pm on December 30th. Access to the warehouse is restricted on the 31st so that no inventory is moved in or out of the facility on the day of the count.
  • Numbered Tags: Each inventory item is tagged, and the tag lists the cost, description, and number of inventory items (if applicable). The tags are numbered and listed on a separate report that is also provided to each person who is counting inventory.
  • Matching: The inventory counters match each item on the detailed inventory listing to a tagged item. Each counter writes the tag number next to the item on the inventory listing. If the information from the tag differs from the inventory listing, that information is also noted on the listing.
  • Exceptions: The accounting staff investigates any differences so that the inventory record can be corrected. The sum of all the adjustments will ensure that the inventory listing matches the physical inventory on hand.

If you keep close track of ending inventory, you’ll know what to expect when the inventory count takes place. For example, many retailers make big purchases in October and November and sell a large amount of inventory before the end of the holiday season. As a result, the ending inventory balance on 12/31 will be much lower than in prior months.

Use the trends and analysis you perform using ending inventory and compare those balances to the inventory count results.

Disadvantages of using the ending inventory formula

The ending inventory formula is not a perfect predictor of the inventory you need to fill orders. These factors impact inventory sales and purchases:

  • Vendor issues: If a vendor can’t buy sufficient raw materials to produce the number of units you need, you may not receive all of the inventory items ordered.
  • Changes in demand: Customers’ preferences change, and economic conditions impact spending habits.
  • Product mix changes: It’s common for a business to lower a product’s sale price based on competition. You may decide to adjust your inventory purchases to focus on products that generate a higher gross profit.

These factors impact inventory management and change the purchase and sales assumptions you use to compute the ending inventory value. No inventory system is perfect, but the formula is your best tool to estimate the amount of inventory needed.

When does using the ending inventory make sense for a business?

Every business that carries inventory should use the ending inventory formula. The inventory calculation helps you to conserve cash while you meet customer demand.

The value of inventory for retailers, manufacturers, and wholesalers may be the largest dollar amount on the balance sheet. For these businesses, managing inventory cost can have a big impact on net income and cash flows.

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