How to Calculate Inventory on the Balance Sheet

Businesses that sell goods rely heavily on inventory, representing items held for sale or used in production. This asset appears on a company’s balance sheet, providing a snapshot of its financial position. Accurate inventory calculation directly impacts a company’s reported assets and overall financial health. Precise inventory figures influence purchasing strategies, pricing, and production schedules. The methods used to value inventory can significantly alter these reported figures.

Understanding Inventory on the Balance Sheet

Inventory is classified as a current asset, expected to be converted to cash, sold, or consumed within one operating cycle (typically a year or less). For manufacturers, inventory generally comprises raw materials, work-in-process (WIP), and finished goods. Retail businesses primarily deal with merchandise inventory, consisting of finished goods purchased for resale.

Raw materials are basic inputs for production, such as wood or fabric. Work-in-process inventory consists of partially completed goods undergoing manufacturing, with some labor and overhead costs applied. Finished goods are products that have completed manufacturing and are ready for sale.

Determining Inventory Cost

Calculating inventory on the balance sheet begins with accurately determining its cost. This encompasses all expenditures necessary to bring inventory to its current location and condition. For merchandise inventory, the primary direct cost is the purchase price. For manufactured goods, cost includes direct materials (raw materials that become a physical part of the finished product), direct labor (wages paid to employees directly working on converting raw materials into finished goods), and manufacturing overhead.

Manufacturing overhead includes all indirect production costs, such as indirect labor, indirect materials, factory rent, utilities, and depreciation of manufacturing equipment. Costs like freight-in and customs duties are also included. Conversely, certain costs are not included in inventory cost and are expensed as incurred. These include selling costs, advertising, sales commissions, and general administrative costs. Storage costs incurred after goods are ready for sale are also usually expensed.

Inventory Valuation Methods

Businesses must choose a method to value their ending inventory and cost of goods sold. The choice can significantly impact financial statements, especially during periods of changing prices. The three primary methods under US GAAP are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and the Weighted-Average method.

The First-In, First-Out (FIFO) method assumes the first goods purchased are the first ones sold. Remaining inventory consists of the most recently acquired items. In rising cost periods, FIFO generally results in higher ending inventory value and lower cost of goods sold, leading to higher reported net income. For example, if 10 units were bought at $10 and 10 at $12, and 15 units sold, FIFO values the 10 units at $10 and 5 units at $12 as sold. The remaining 5 units are valued at $12.

The Last-In, First-Out (LIFO) method assumes the last goods purchased are the first ones sold. Remaining inventory is composed of the earliest acquired items. During rising costs, LIFO typically results in lower ending inventory value and higher cost of goods sold, leading to lower reported net income and lower income tax liability. For the same example, if 15 units were sold, LIFO values the 10 units at $12 and 5 units at $10 as sold. The remaining 5 units are valued at $10. LIFO is permitted under US GAAP but not under International Financial Reporting Standards (IFRS).

The Weighted-Average method calculates the average cost of all goods available for sale. This average cost is applied to both ending inventory and cost of goods sold. This method smooths out price fluctuations, resulting in inventory values and cost of goods sold figures that fall between FIFO and LIFO. For example, if a business had 10 units at $10 and 10 units at $12, the total cost of 20 units is $220. The weighted-average cost per unit is $11. If 15 units were sold, cost of goods sold is $165, and ending inventory of 5 units is valued at $55.

Physical Inventory and Adjustments

Conducting a physical count of inventory is important for accuracy. This involves manually counting all items on hand to verify quantities recorded in company records. Discrepancies are common, arising from theft, damage, obsolescence, or human errors.

Once discrepancies are identified, adjustments must be made to the inventory value. If goods are damaged or obsolete, their value may need to be written down. Accounting standards generally require inventory to be reported at the lower of its cost or net realizable value (LCNRV) for most entities, or lower of cost or market (LCM) for those using LIFO or retail inventory methods. Net realizable value is the estimated selling price less reasonably predictable costs of completion, disposal, and transportation. If this value falls below the recorded cost, a write-down reduces the inventory’s carrying amount on the balance sheet and recognizes an expense.

Presenting Inventory on the Balance Sheet

The final calculated inventory value is presented on the balance sheet as a current asset, typically listed after cash and accounts receivable due to its liquidity. This figure represents the cost of goods a company has on hand, ready for sale or consumption. Financial statements also include disclosure notes.

These notes provide transparency by explicitly stating the inventory costing method (FIFO, LIFO, or Weighted-Average) the company has chosen. This disclosure impacts reported asset value, cost of goods sold, and ultimately, net income and tax obligations. For example, during inflationary periods, a company using LIFO will generally report lower net income and lower inventory values compared to a company using FIFO, which can affect profitability metrics and tax liabilities. Understanding these disclosures is important for financial analysis.