How to Calculate Ending Merchandise Inventory

Ending merchandise inventory represents the value of goods a business has available for sale at the close of an accounting period. This figure is fundamental in accounting, directly influencing the Cost of Goods Sold (COGS) on the income statement and appearing as a current asset on the balance sheet. Accurately determining ending inventory is crucial for understanding profitability, assessing asset value, ensuring reliable financial reporting, and making informed inventory management decisions.

Understanding Inventory Systems

Businesses employ one of two primary inventory accounting systems: periodic or perpetual. These systems dictate how inventory levels are tracked and updated throughout an accounting period. The choice of system influences the frequency and nature of inventory record-keeping.

The periodic inventory system updates inventory and COGS only at the end of an accounting period, often requiring a physical count. This system suits smaller businesses or those with lower transaction volumes, as it does not provide real-time inventory balances.

In contrast, the perpetual inventory system continuously tracks inventory balances and COGS for every sale and purchase. This system often relies on technology like barcode scanners and Point of Sale (POS) systems for real-time data. Businesses with high sales volumes, valuable inventory, or multiple locations frequently use a perpetual system for its immediate stock level view.

Gathering Data for Valuation

Before any calculation method can be applied, specific data points must be accurately gathered to determine ending inventory. The initial inventory on hand at the start of an accounting period, known as beginning merchandise inventory, is the first key piece of information. This figure is typically derived from the ending inventory balance of the previous accounting period.

Net purchases represent the total cost of all inventory acquired during the period, adjusted for any returns, allowances, or discounts. Once beginning inventory and net purchases are determined, they combine to calculate the Cost of Goods Available for Sale (COGAS). This figure signifies the total cost of all merchandise available for sale during the period.

For certain estimation methods, sales revenue figures are also necessary. While not directly used in all ending inventory calculations, they are important inputs for methods like the Gross Profit Method or the Retail Inventory Method.

Applying Cost Flow Assumptions

Once the necessary data is gathered, businesses apply cost flow assumptions to determine the value of their ending inventory. These methods allocate costs to the items sold and to those remaining in inventory. The chosen assumption does not necessarily reflect the physical flow of goods but provides a systematic way to assign costs.

The First-In, First-Out (FIFO) method assumes that the first goods purchased are the first ones sold. Consequently, ending inventory is valued using the costs of the most recently purchased items. For example, if 60 units are sold from a purchase of 100 units at $10 and 100 units at $15, FIFO assumes the $10 units were sold first. This leaves remaining inventory valued at the $10 and $15 costs, generally reflecting current market prices.

The Last-In, First-Out (LIFO) method assumes that the last goods purchased are the first ones sold. Ending inventory is thus composed of the costs of the earliest purchased items. If, in the previous example, 60 units were sold under LIFO, they would be assumed to come from the $15 batch, leaving the ending inventory valued at the earlier $10 costs. LIFO is not permitted under International Financial Reporting Standards (IFRS) due to potential distortions in financial statements.

The Weighted-Average method calculates an average cost for all goods available for sale. This average cost is then applied to both units sold and units remaining in ending inventory. This approach smooths out price fluctuations, providing a consistent cost per unit.

The Specific Identification method is used when individual inventory items are unique and can be distinctly identified. This method directly matches the cost of each specific item to its sale or its presence in ending inventory. It is typically applied to high-value goods, such as automobiles or custom jewelry, where each item has a traceable cost.

Using Estimation Methods

When a physical inventory count is impractical or impossible, such as during interim reporting or after a disaster, businesses can use estimation methods to determine ending inventory. These methods provide a reasonable approximation of inventory value, relying on historical data and established relationships between costs and sales.

The Retail Inventory Method estimates ending inventory using a cost-to-retail ratio. This method is useful for retailers with a large volume of similar items. The process involves calculating the cost of goods available for sale at both cost and retail prices, then determining a cost-to-retail ratio. Estimated sales at retail are subtracted from goods available for sale at retail to find the ending inventory at retail, which is then converted back to cost using the ratio.

The Gross Profit Method estimates ending inventory by applying a historical gross profit percentage to current sales figures. This method is often used for interim financial statements or for insurance claims when inventory has been damaged or destroyed. The calculation begins by determining the Cost of Goods Available for Sale. The estimated Cost of Goods Sold is then derived by subtracting the estimated gross profit (sales multiplied by the historical gross profit percentage) from sales. Finally, the estimated ending inventory is found by subtracting the estimated Cost of Goods Sold from the Cost of Goods Available for Sale.