How to Calculate Ending Merchandise Inventory

Calculating the value of ending merchandise inventory is a fundamental process for businesses that buy and sell goods. This figure represents the cost of products still on hand at the close of an accounting period, directly influencing both the balance sheet and the income statement. Ending inventory is reported as a current asset on the balance sheet and is crucial for determining the cost of goods sold (COGS), which in turn impacts a business’s reported profit.

Accurate ending inventory figures provide insights into a company’s financial health, help in managing stock levels, and inform purchasing and pricing strategies. Businesses must consistently apply their chosen inventory accounting methods to ensure financial reports are comparable and reliable. Understanding the methods involved helps businesses maintain precise financial records and make informed operational decisions.

Performing a Physical Inventory Count

A direct and often most accurate method for determining inventory quantities is a physical count. This process involves manually counting all merchandise on hand at a specific point in time. Businesses typically schedule these counts when operations are minimal, such as after hours or on weekends, to reduce disruptions and ensure accuracy.

Effective planning and preparation are crucial for a successful physical inventory. This includes organizing the inventory area, clearly labeling items and storage locations, and assigning specific roles to counting teams. Teams then systematically count items, often using pre-numbered count tags or handheld scanning devices to record quantities and product details.

After the initial count, a verification and reconciliation phase follows. This involves double-checking counts, especially for high-value items, and comparing physical counts against existing inventory records. Any discrepancies are investigated and resolved to ensure the accuracy of the final inventory figures. Once quantities are confirmed, they are then assigned a cost, which leads to the valuation of the ending inventory.

Applying Inventory Cost Flow Methods

Once the physical quantity of inventory is known, businesses must assign a cost to these items to determine the total value of ending merchandise inventory. This is particularly relevant when identical goods are acquired at different prices over time. Generally Accepted Accounting Principles (GAAP) allow for several cost flow assumptions to facilitate this valuation.

First-In, First-Out (FIFO)

The First-In, First-Out (FIFO) method assumes that the first goods purchased are the first ones sold. Consequently, the cost of the most recently purchased items remains in ending inventory. This method often aligns with the physical flow of goods, especially for perishable items or those with expiration dates.

For example, a business has a beginning inventory of 10 units at $10, then purchases 20 units at $12, and 15 units at $15. If 30 units are sold, FIFO assigns the cost of the first 10 units ($100) and 20 units from the first purchase ($240) to cost of goods sold, totaling $340. The ending inventory consists of the remaining 15 units from the second purchase ($15 x 15 = $225). In periods of rising prices, FIFO generally results in a higher ending inventory value and lower cost of goods sold.

Last-In, First-Out (LIFO)

The Last-In, First-Out (LIFO) method operates under the assumption that the last goods purchased are the first ones sold. This means the cost of the oldest inventory items remains in ending inventory. LIFO is permitted under U.S. GAAP but is prohibited under International Financial Reporting Standards (IFRS).

Using the same example: beginning inventory of 10 units at $10, first purchase of 20 units at $12, and second purchase of 15 units at $15. If 30 units are sold, LIFO assigns the cost of the 15 units from the most recent purchase ($225) and 15 units from the preceding purchase ($180) to cost of goods sold, totaling $405. The ending inventory would then be the remaining 5 units from the first purchase ($60) and the 10 units from beginning inventory ($100), totaling $160. During periods of rising prices, LIFO typically results in a lower ending inventory value and higher cost of goods sold compared to FIFO.

Weighted-Average Method

The Weighted-Average Method calculates the average cost of all goods available for sale during a period. This average cost is then applied to both the units sold and the units remaining in ending inventory. This method is often favored for its simplicity, especially when inventory items are indistinguishable.

Consider the same inventory: 10 units at $10, 20 units at $12, and 15 units at $15. The total units available for sale are 45. The total cost of goods available for sale is $100 + $240 + $225 = $565. The weighted-average cost per unit is $565 / 45 units = $12.56 (rounded). If 30 units are sold, the cost of goods sold would be $12.56 x 30 = $376.80. The ending inventory of 15 units would be valued at $12.56 x 15 = $188.40.

Specific Identification Method

The Specific Identification Method is used when individual inventory items can be uniquely identified and their exact cost tracked. This method is typically applied to high-value, non-interchangeable items, such as custom-made furniture or unique pieces of art. While it accurately matches the cost of specific items to their sale, its practical application is limited for businesses with a large volume of similar, low-cost merchandise.

Estimating Inventory When a Count Isn’t Possible

There are situations where a physical inventory count is not feasible or practical, such as for preparing interim financial statements or after an unforeseen event like a disaster. In these cases, businesses can estimate ending inventory using accounting methods that rely on historical data and financial relationships.

Gross Profit Method

The Gross Profit Method estimates ending inventory by using a business’s historical gross profit percentage. This method assumes that the gross profit rate remains relatively consistent over time. It is particularly useful for interim reporting or for estimating inventory losses due to theft or damage.

To calculate ending inventory, determine the cost of goods available for sale (beginning inventory + net purchases). Then, estimate the cost of goods sold by multiplying net sales by the complement of the historical gross profit percentage (1 minus the gross profit percentage). Finally, subtract the estimated cost of goods sold from the cost of goods available for sale.

For example, if a business had beginning inventory of $50,000 and purchases of $150,000, goods available for sale would be $200,000. With sales of $180,000 and a historical gross profit percentage of 30%, the estimated cost of goods sold is $180,000 x 0.70 = $126,000. Estimated ending inventory is then $200,000 – $126,000 = $74,000.

Retail Inventory Method

The Retail Inventory Method is commonly used by retail businesses to estimate the cost of ending inventory. This method relies on the relationship between the cost of merchandise and its retail selling price. It simplifies the estimation process by converting ending inventory at retail prices back to cost.

Compute the cost-to-retail ratio by dividing the cost of goods available for sale by their retail selling price. Determine the ending inventory at retail by subtracting sales from goods available for sale at retail. Finally, multiply the ending inventory at retail by the cost-to-retail ratio to estimate the ending inventory at cost.

For instance, a retailer might have beginning inventory costing $30,000 (retail $50,000) and purchases costing $70,000 (retail $100,000). Total goods available for sale are $100,000 at cost and $150,000 at retail. The cost-to-retail ratio is $100,000 / $150,000 = 0.667 or 66.7%. If sales were $90,000, ending inventory at retail is $150,000 – $90,000 = $60,000. Estimated ending inventory at cost is $60,000 x 0.667 = $40,020. This method is most effective when a consistent markup percentage is applied across products.