At the end of each accounting period, there’s a certain amount of stock on hand that you haven’t sold or used — often a combination of finished goods, raw materials, and works-in-process (or works-in-progress).
The value of that stock is called ending inventory (or closing inventory). And figuring out that value is essential for determining your company’s financial health and operational efficiency.
This guide will teach you how to calculate ending inventory to maintain precise inventory records, optimize stock levels, and enhance your business’s overall profitability.
The ending inventory formula
You can find ending inventory calculators online, but it’s also fairly simple to do yourself. You’ll just add the period’s net purchases to the beginning inventory, then subtract the cost of goods sold (COGS).
Here’s the formula:
Ending Inventory = Beginning Inventory + Net Purchases – Cost of Goods Sold (COGS)
Ending inventory costing methods
There’s no one right method used to value closing inventory — different businesses have different needs. But the method you choose does impact how you determine COGS, which then feeds into the ending inventory calculation.
Let’s break down the main inventory costing methods — FIFO, LIFO, and weighted average cost — before diving into the three methods designed for calculating ending inventory.
First in, first out (FIFO)
The FIFO costing method assumes your oldest inventory is sold first. When you sell goods, the cost of the oldest stock is used to calculate COGS, leaving newer, potentially more expensive items in your ending inventory.
- Best for:
- Perishable goods like food or pharmaceuticals where selling the oldest items first is essential.
- Businesses that want their inventory value to reflect current market prices.
- Drawback: During periods of inflation, the FIFO method can lead to higher profits and, consequently, higher taxes.
Last in, first out (LIFO)
As the name suggests, the LIFO costing method assumes the newest inventory is sold first. With the LIFO method, you’ll calculate COGS using the cost of the most recently acquired items, leaving older, potentially cheaper items in ending inventory.
- Best for: Businesses aiming to reduce tax liabilities during inflationary periods (as higher COGS leads to lower taxable income).
- Drawbacks:
- Not allowed under IFRS: LIFO is prohibited under International Financial Reporting Standards (IFRS), limiting its use internationally.
- Potential for understated inventory value: The LIFO method can distort a company’s financial position and potentially mislead investors.
- LIFO liquidations: Significantly reducing inventory levels can trigger a “LIFO liquidation” of older inventory, causing a sudden increase in profits and taxes.
Weighted average cost
Instead of accounting for cost variations like the FIFO or LIFO methods, the weighted average cost method averages the cost of all inventory throughout the accounting period, creating a consistent COGS and ending inventory value.
The method’s application will depend on whether a periodic or perpetual inventory system is in use. With periodic inventory, the average cost would be calculated at the end of the period based on the total cost of goods available for sale. For perpetual inventory, the average cost would be recalculated after each inventory purchase, reflecting any cost changes in real time.
- Best for: The weighted average method works best for businesses dealing with large quantities of materials, commodities, or other interchangeable goods.
- Drawback: This method is more straightforward than FIFO and LIFO but doesn’t show cost fluctuations, which can limit insights into cost trends and profitability analysis.
3 methods for calculating ending inventory
Once you’ve determined the costing method you’ll work with to calculate COGS, you’re ready to select a method for calculating ending inventory.
1. Gross profit method
This method estimates ending inventory based on the gross profit margin.
- How it works:
- Calculate your cost of goods available for sale (beginning inventory + purchases).
- Estimate your COGS based on your gross profit margin.
- Subtract the estimated COGS from the cost of goods available for sale to arrive at the estimated ending inventory.
- Impact of costing methods:
- FIFO: Lower COGS during inflation generally leads to higher ending inventory values.
- LIFO: Higher COGS results in lower ending inventory values.
- Weighted Average: The weighted average method provides a more stable estimate by smoothing out cost fluctuations.
Example calculation
The example below illustrates how the gross profit method uses your gross profit margin to estimate COGS instead of calculating it directly — a method that’s useful when you can’t realistically complete a physical count. The key difference is the reliance on your profit margin as an estimation tool rather than using exact cost data.
- Beginning inventory: $50,000
- Net purchases: $30,000
- Sales for the period: $100,000
- Gross profit margin: 40%
- Estimated COGS: Sales x (1 – Gross Profit Margin) = $100,000 x 0.60 = $60,000
- Cost of goods available for sale: Beginning Inventory + Net Purchases = $50,000 + $30,000 = $80,000
- Ending inventory: Cost of Goods Available for Sale – Estimated COGS = $80,000 – $60,000 = $20,000
2. Work-in-process method
The work-in-process (WIP) method tracks partially completed goods by factoring in direct materials, labor, and overhead. Unlike the gross profit method, which estimates inventory broadly based on sales and profit margins, the WIP method provides a more detailed, accurate breakdown of unfinished goods. This method is ideal for manufacturers or businesses with production cycles that involve partially completed inventory, especially if production costs tend to vary or if the business needs precise insights into their manufacturing efficiency.
- Impact of costing methods:
- FIFO: Uses older, potentially cheaper materials, which may cause lower WIP value during inflation.
- LIFO: Uses the cost of newer, potentially more expensive materials, increasing WIP value.
- Weighted average cost: Balances costs for a stable WIP value.
Example
Let’s go through an example to see how the WIP method accounts for costs throughout the production process. You’ll begin with the value of your partially completed inventory, then add direct production costs for the period. After that, you’ll subtract the costs of goods that were completed and moved to finished inventory, leaving you with a precise value for all the unfinished inventory that remains at the end of the period.
- Beginning WIP inventory: $15,000
- Costs added during the period: $30,000
- Costs of goods completed and transferred out: $30,000
- Ending WIP inventory: $15,000 + $30,000 – $30,000 = $15,000
3. Retail method
The retail method estimates ending inventory by applying a cost-to-retail ratio — a percentage that represents the relationship between the cost of goods and their retail price. This method is especially useful for retailers with large inventories of similar goods where it would be too time-consuming to track the cost of each individual item.
- How it works:
- Determine the cost-to-retail ratio (cost of goods available for sale / retail value of goods available for sale).
- Calculate the ending inventory at retail value.
- Multiply the ending inventory at retail value by the cost-to-retail ratio to estimate ending inventory at cost.
- Impact of costing methods:
- FIFO: Leads to a lower cost-to-retail ratio, potentially increasing the estimated ending inventory value.
- LIFO: Produces a higher ratio, potentially decreasing the estimated ending inventory value.
- Weighted average cost: Provides a middle-ground ratio.
Example
The retail method is helpful for finding a quick estimate when you don’t have time to itemize costs, but since it assumes consistent markup percentages, it’s less accurate if you don’t account for factors like markdowns or pricing changes. Let’s look at another example to see how this method simplifies inventory valuation by estimating the cost of ending inventory using the relationship between cost and retail price.
- Total cost of goods available for sale: $60,000
- Total retail value of goods available for sale: $100,000
- Cost-to-retail ratio: $60,000 / $100,000 = 0.6
- Ending inventory at retail value: $20,000
- Ending inventory cost: $20,000 x 0.6 = $12,000
Important note: The methods used to value closing inventory and inventory costing will have a big impact on your financial statements and tax liabilities, so consult with an accounting professional to find the best choice for your business needs.
4 ways to use ending inventory
Knowing how to find ending inventory is step one. Next, you need to learn how to use that number in your business. Here are some common uses.
1. Accurate financial reporting
Ending inventory is a key component of your balance sheet, which is a crucial financial statement that provides a snapshot of your company’s assets, liabilities, and equity at a specific point in time. Accurate ending inventory valuation ensures that your financial statements present a true and fair view of your company’s financial position. That’s essential for attracting investors, securing loans, and making informed business decisions.
2. Optimizing stock levels
Knowing your ending inventory helps you understand how effectively you’re managing your stock. By analyzing trends in ending inventory over time, you can identify potential issues like overstocking or stockouts, which allows you to:
- Minimize holding costs: Avoid tying up too much capital in excess inventory, reducing storage, insurance, and obsolescence costs.
- Meet customer demand: Ensure you have enough inventory to fulfill orders and avoid lost sales due to stockouts.
- Improve cash flow: Optimize inventory levels to free up cash for other business needs.
3. Aligning inventory with market demand and business goals
By tracking ending inventory, you can gain insights into sales patterns, product popularity, and overall market demand. With this information, you can:
- Adjust purchasing decisions: Make informed decisions about the quantity and type of inventory to purchase.
- Identify slow-moving items: Implement strategies to clear out obsolete or slow-selling inventory.
- Align inventory with business goals: Ensure your inventory strategy supports overall business objectives like growth, profitability, or market share expansion.
4. Benchmarking performance across locations
Calculating ending inventory on a per-location basis allows you to compare the performance of different warehouses or stores. By considering factors like square-foot storage space, inventory turnover, and total unit sales in relation to ending inventory, you can:
- Identify operational inefficiencies: Pinpoint locations with excessive inventory holding costs or slow-moving stock.
- Optimize inventory distribution: Ensure the right products are in the right place at the right time.
- Improve overall supply chain management: Streamline your inventory operations across all locations.
Take the guesswork out of ending inventory with Fishbowl
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