How to Calculate the Ending Inventory
One of the most critical activities when closing a financial year is calculating the ending inventory. It is every business man’s responsibility to know how much is left at the end of such an accounting season to plan how to start the next. However, it is a common myth that such serious accounting is only for big companies or companies with hundreds of employees. This can only be far from the truth.
All businesses, whether big, medium or small, have to have proper accounting structures. This will help them have a better footing in the industry and have the right answers if any legal challenges face them in the future.
What is the Ending Inventory?
Ending inventory is the amount of saleable stock left at the end of an accounting season. This helps to tell companies what needs to be added or deducted from future stocking endeavors. It can also be useful when discussing other companies’ financial and production matters.
There are two ways to structure different ways of calculating the ending inventory. The first method includes LIFO, FIFO, and weight average cost (WAC). This helps to answer the valuing query. The other classification involves physically counting the remaining stock, using quantities in the company’s inventory system, and estimating ending inventory value. Both classification methods somehow intertwine what a business needs to know about its ending inventory. However, we will look at all the ways to give you a better standing when trying to choose which one to use.
The most general formula you can use to ease your process when calculating your ending inventory is adding the beginning inventory (BI) to net purchases (NP) and subtracting the cost of goods sold (COGS).
BI + NP – COGS = Ending inventory
Why You Need to Calculate the Ending Inventory
You always want to know what you are selling, if it is available in stock, or you need to replenish your stores. Other than this reason, here is why you should take time calculating your ending inventory seriously.
1. It helps you match your records with what you physically have in storage.
You will often find that you have a number on your records that does not match the actual amount of inventory present. If your company works with perishables, then this might have been a case of something that got spoilt, thrown away but never recorded. When going through your inventory, you ensure that such claims are on record, so no one is pointing fingers at another wrongly.
2. It is part of what you need when calculating your net income.
The only way you can tell how your business is doing is by calculating the net income. Your inventory will be a part of such calculations since you will have to take what you bought at the beginning of the year, plus what was added, minus what is remaining to estimate how much you should have made in sales.
3. Ensures you are always in the know of everything that goes in and out of the business building.
How can you tell that you know your business’s operation if you cannot even tell where the goods are going and how many you have in store? It is simple accountability practices that mirror the kind of a business manager a person is.
How to Calculate the Ending Inventory using Classification Method
This classification offers an overall elaboration of how one can calculate their ending inventory.
Counting the Item Physically
This is the simplest and surest way to know how much inventory you have in stock. Once you have physically counted each item, you multiply the numbers with their recorded value. The numbers you get after this practice should coincide with the cash flow assumption your business uses, i.e., LIFO or FIFO.
This process is, however, time-consuming and can be tedious. It is workable for small businesses, but once the company starts growing, one needs to get a better method to keep everything accounted for. However, one can still commit to have the process done at least once every year to have exact figures and not mere assumptions.
Counting by Quantities in the Inventory System
This is an excellent method when going through books of accounting for interim statements. Here, you only use the company’s inventory system to get the number of pieces available. You then use these numbers to multiply with the units’ values.
You can randomly perform this step without having to involve too many people. Since it is a matter of items already recorded in the system with an absolute trust that they were recorded correctly, you will not take too much time to get the final figures.
Although this process might not be as accurate as physically counting inventory in stock, companies are encouraged to perform it frequently to make better operational decisions.
The Estimating Method
The third and final method in this classification is using gross profits to estimate the amount of inventory. To calculate using the gross profit method, follow the following steps:
- Sum up the cost of inventory at the beginning of the period to the cost of all purchases all through the chosen period. You will get the value of the available stock.
- Use the gross profit percentage to multiply by recorded sales. This will give you an estimated amount of the cost of goods sold.
- Subtract what you get from 2. To what you got from 1. This will give you the estimated ending inventory of the period at hand.
All the three described methods above will give you viable figures to work with when calculating the ending inventory. However, before you conclude this, you will also need to account for the work in progress ending inventory. This inventory might be technically not within the storage, but its sales process is yet to be completed. They could be in transit, or the buyer is yet to finalize their payment. Such goods should also be accounted for before you stump your records as accurate and done.
To get these figures right, you can easily subtract the ending inventory from the cost of goods sold, especially when there seems to be some amount not accounted for. For manufacturing companies, you can use this formula:
Beginning work in progress + manufacturing costs – cost of goods manufactured
This will give you the ending work in progress. You can use this to estimate inventory as well. However, you will still need to physically count or use a cycle counting program to get more accurate figures. In business, the more precise the numbers, the better for both the company and other stakeholders.
How to Calculate the Ending Inventory using Classification Methods 2
It is vital to note that the method you use to value ending inventory will directly affect decisions made in the company. You, therefore, need to choose your methods correctly.
1. First in, First out method (FIFO)
In this inventory accounting method, one assumes that the inventory that first gets into the company’s stores is the first one to go out or buyers purchase them first. This method adds your current list to your cost of goods sold before including earlier purchases. It often means that the goods that first came into the company are already out, so what you have is at the most current inventory price.
This method will give you higher figures, and business owners prefer it, especially during inflations or a period of high prices.
For example, say you purchased two seats at $2000 each. Some months later, you added two other seats of the same design but costing $2500 each. A customer came and purchased two of the total seats you have. When calculating the ending inventory using FIFO, it will mean that the seats you sold were the first to come in, meaning the cost of goods sold will be $4000 for both seats.
If you add another seat and one more gets a buyer, then the cost of goods sold will be $2500 per seat even if the new seat in the inventory came in at $2400. The cycle goes on and on until the most recent list gets a buyer.
2. Last in, First out method (LIFO)
This works opposite to the other method. In this case, businesses assume that the most recent inventory is the one that is sold first, and the old list stays longer in their storehouse. They, therefore, value their inventory based on the current market pricing.
Using the same example as illustrated above, it would mean that you would use the most current purchasing prices to account for your inventory. Therefore, the first sales will be at $5000 and not $4000. This will mean that you sold the seats that came in last and still had your older seats. For the second purchase, you will record $2400 and not $2000. Therefore, you will need not bring in any other seats if you wanted the once valued at $2000 to go. Of course, this might not be literal, but the accounting method suggests so.
When there are decreasing prices, accountants would rather go for this method as it somehow ensures that they keep the profits high.
3. The Weight Average Method (WAC)
In this case, you take the total amount of all the inventory you have at hand, and use is it to divide the total amount you spent on the list. This will give you an average cost for each unit.
Back to the example we have used before; you purchased the first two seats at a total of $4000 and the next two at a total of $5000. You, therefore, have all inventory valuing at $9000 in total. To get the cost of each unit, you will divide the $9000 by four units. This will make $2250 each. When any seat gets a buyer, you will value them at the average price. This means that when the buyer gets the two seats, you will record the total cost of goods sold at $4500.
WAC might as well be the most practical of the three methods. It is also simpler since when buying stock in bulk, you often get a wholesome discount and not one per unit. It is useful through both high and low seasons, without one having to manipulate the numbers to increase profit.
How Ending Inventory is Used
No matter how much you want to protect your inventory from market inflation, the ending list will always take the value as per the market or at the lowest price of the goods you have. You will then add the cost of the inventory to the value of the stock as the next period begins.
In some cases, you find the market value price of your inventory higher than associated costs. However, this can change quickly when there is a drastic market change or the goods depreciate/become obsolete. When this happens, the market value of your goods will be much lower than the good’s original value. It will mean a significant loss to your asset’s value.
Therefore, you are encouraged to stay up to date with market changes and maybe even use statistical tools to predict any changes. At the end of the day, the market’s demand and supply curve will determine how much your inventory is worth and how much you will be able to sell. This will not always favor the original buying price.
Accounting for your inventory might not be the easiest thing to do, but it could as well be termed as the core of your business. When your inventory is working right, you are getting more profits and better value for your transactions. The opposite is also true. Keeping these facts in mind will help you understand why calculating the ending inventory is also quite important. Do not wait for the end of the year before you know what you have remaining in stock to be on the safe side. Interim accounting ensures that the end part is much easier and less involving.