How to Calculate Ending Inventory

Ending inventory represents the monetary value of goods a business has available for sale at the conclusion of an accounting period. It reflects the assets that will generate future revenue and provides insight into how well a company manages its purchasing and sales cycles. The valuation of this inventory is a regulated process that directly influences reported profits and tax liabilities.

The Ending Inventory Formula

The calculation of ending inventory is grounded in a standard accounting formula that connects a company’s inventory flows. The formula is: Beginning Inventory + Net Purchases – Cost of Goods Sold (COGS) = Ending Inventory. This equation determines the value of inventory remaining after accounting for all goods sold during a period.

Beginning inventory is the value of goods carried over from the previous accounting period. Net purchases represent the total cost of all new inventory acquired, factoring in adjustments for returns, allowances, and discounts. The Cost of Goods Sold (COGS) encompasses all direct costs associated with producing or acquiring the goods that a company has sold.

To illustrate, a business starts a quarter with $20,000 in inventory and purchases an additional $50,000 worth of goods. If the Cost of Goods Sold for the quarter is $40,000, the formula is applied as follows: $20,000 (Beginning Inventory) + $50,000 (Net Purchases) – $40,000 (COGS). The resulting $30,000 is the ending inventory value.

Inventory Counting Systems

Before a monetary value can be assigned to inventory, a company must determine the physical quantity of goods it possesses. One approach is the periodic inventory system, which involves a physical count of all inventory on hand at the end of an accounting period. This manual process requires temporarily halting operations to count every item.

The information from a periodic count is used to update accounting records and calculate the cost of goods sold for the period. This system can be simpler and less expensive to implement, making it suitable for smaller businesses. The primary drawback is the lack of real-time inventory data, which can lead to stockouts or overstocking.

A more advanced method is the perpetual inventory system, which continuously tracks inventory levels as goods are bought and sold. This system relies on technology, such as barcode scanners and software, to provide a real-time record of inventory quantities. Every sale or purchase immediately updates the inventory database, offering a constant view of stock levels and allowing for immediate calculation of COGS.

Inventory Costing Methods

Once the quantity of inventory is known, a costing method must be applied to assign a dollar value to the items. The First-In, First-Out (FIFO) method operates on the assumption that the first units purchased are the first ones sold. In an environment of rising prices, items sold are assigned the older, lower costs, while items in inventory are valued at the more recent, higher costs. This results in a higher ending inventory value and a lower cost of goods sold.

Consider a business that makes two purchases: 10 units at $5 each and then 10 units at $7 each. If the company sells 12 units, FIFO assumes the first 10 units sold were those purchased at $5, and the remaining 2 units sold were from the $7 batch. The COGS would be (10 x $5) + (2 x $7) = $64. The ending inventory would consist of the 8 remaining units from the second purchase, valued at $7 each, for a total of $56.

The Last-In, First-Out (LIFO) method works on the opposite assumption: the last units purchased are the first ones sold. Using the same example, when 12 units are sold, LIFO dictates that the 10 units purchased at $7 are sold first, followed by 2 units from the initial $5 purchase. The COGS is $80, and the ending inventory is $40. Internal Revenue Code Section 472 requires that if LIFO is used for tax purposes, it must also be used for financial reporting.

The Weighted-Average Cost (WAC) method values both the cost of goods sold and ending inventory based on the average cost of all similar goods available for sale. In our example, the total cost of 20 units is $120, making the weighted-average cost per unit $6. The COGS for the 12 units sold would be $72, and the ending inventory of 8 units would be valued at $48.

The specific identification method is used for items that are unique and not interchangeable, such as custom jewelry or automobiles. Each individual item’s cost is tracked from purchase to sale. If a business sold a specific item that cost $1,000, the COGS for that sale is exactly $1,000. This method provides the most accurate matching of costs to revenues for high-value, distinct goods.

Impact on Financial Statements

The calculated ending inventory value has a direct impact on a company’s financial statements. On the balance sheet, ending inventory is reported as a current asset. This figure represents a component of a company’s working capital and liquidity, as it is an asset expected to be converted into cash within one year. The value assigned to inventory affects the total current assets and the overall financial position.

The choice of inventory costing method also influences the income statement. A higher ending inventory value results in a lower COGS, which in turn leads to a higher reported gross profit and net income. For instance, using FIFO during a period of rising prices yields a higher ending inventory and higher net income compared to LIFO.

This relationship is important for tax planning, as a lower reported net income, often achieved through LIFO, can lead to a lower tax liability. The selection of an inventory valuation method is a strategic decision with financial consequences. Companies must consistently apply their chosen method, as required by Generally Accepted Accounting Principles (GAAP), to ensure comparability of financial results over time.