What Is Ending Inventory?
Ending inventory is the value of goods still available for sale and held by a company at the end of an accounting period. The dollar amount of ending inventory can be calculated using multiple valuation methods. Although the physical number of units in ending inventory is the same under any method, the dollar value of ending inventory is affected by the inventory valuation method chosen by management.
- Ending inventory is an important component in the calculation of cost of goods sold.
- The method chosen to assign a dollar value to inventory and COGS impacts values on both the income statement and balance sheet.
- There are three common valuation methods for inventory: FIFO (first in, first out), LIFO (last in, first out), and weighted-average cost.
Understanding Ending Inventory
At its most basic level, ending inventory can be calculated by adding new purchases to beginning inventory, then subtracting the cost of goods sold (COGS). A physical count of inventory can lead to more accurate ending inventory. But for larger businesses, this is often unpractical. Advancements in inventory management software, RFID systems, and other technologies leveraging connected devices and platforms can ease the inventory count challenge.
Ending inventory is a notable asset on the balance sheet. It is essential to report ending inventory accurately, especially when obtaining financing. Financial institutions typically require that specific financial ratios such as debt-to-assets or debt-to-earnings ratios be maintained by the date of audited financials as part of a debt covenant. For inventory-rich businesses such as retail and manufacturing, audited financial statements are closely monitored by investors and creditors.
Inventory may also need to be written down for various reasons including theft, market value decreases, and general obsolescence in addition to calculating ending inventory under typical business conditions. Inventory market value may decrease if there is a large dip in consumer demand for the product. Similarly, obsolescence may occur if a newer version of the same product is released while there are still items of the current version in inventory. This type of situation would be most common in the ever-changing technology industry.
Auditors may require that companies verify the actual amount of inventory they have in stock. Doing a count of physical inventory at the end of an accounting period is also an advantage, as it helps companies determine what is actually on hand compared to what's recorded by their computer systems. Any discrepancy between a company's actual ending inventory versus what's listed in its automated system may be due to shrinkage—a loss of inventory for any number of reasons including theft, vendor or accounting errors, problems with delivery, or any other related issue.
The term ending inventory comprises three different types of materials. Raw materials are those used in the primary production process or materials that are ready to be manufactured into completed goods. The second, called work-in-process, refers to materials that are in the process of being converted into final goods. The last category is referred to as finished goods. These goods have gone through the production process and are ready to be sold to consumers.
The inventory valuation method chosen by management impacts many popular financial statement metrics. Inventory-related income statement items include the cost of goods sold, gross profit, and net income. Current assets, working capital, total assets, and equity come from the balance sheet. All of these items are important components of financial ratios used to assess the financial health and performance of a business.
Last In, First Out (LIFO)
Last in, first out (LIFO) is one of three common methods of allocating cost to ending inventory and cost of goods sold (COGS). It assumes that the most recent items purchased by the company were used in the production of the goods that were sold earliest in the accounting period. In other words, it assumes the last items ordered are sold first. Under LIFO, the cost of the most recent items purchased are allocated first to COGS, while the cost of older purchases are allocated to ending inventory—which is still on hand at the end of the period.
First In, First Out (FIFO)
First in, first out (FIFO) assumes that the oldest items purchased by the company were used in the production of the goods that were sold earliest. Simply, this method assumes the first items ordered are sold first. Under FIFO, the cost of the oldest items purchased are allocated first to COGS, while the cost of more recent purchases are allocated to ending inventory—which is still on hand at the end of the period.
During a period of rising prices or inflationary pressures, FIFO (first in, first out) generates a higher ending inventory valuation than LIFO (last in, first out).
Weighted-Average Cost (WAC)
The weighted average cost method assigns a cost to ending inventory and COGS based on the total cost of goods purchased or produced in a period divided by the total number of items purchased or produced. It "weights" the average because it takes into consideration the number of items purchased at each price point.
Examples of Calculating Ending Inventory
To highlight the differences, let's take a look at the same situation with ABC Company using each of the three valuation methods from above. ABC Company made multiple purchases throughout the month of August that added to its inventory, and ultimately its cost of goods sold. This is the company's inventory ledger:
|Purchase Date||Number of Items||Cost Per Unit||Total Cost|
The first step is to figure out how many items were included in COGS and how many are still in inventory at the end of August. ABC company had 200 items on 7/31, which is the ending inventory count for July as well as the beginning inventory count for August. As of 8/31, ABC Company completed another count and determined they now have 300 items in ending inventory. This means that 700 items were sold in the month of August (200 beginning inventory + 800 new purchases - 300 ending inventory). Alternatively, ABC Company could have backed into the ending inventory figure rather than completing a count if they had known that 700 items were sold in the month of August.
The next step is to assign one of the three valuation methods to the items in COGS and ending inventory. Let's assume the 200 items in beginning inventory, as of 7/31, were all purchased previously for $20.
- Using LIFO, the 700 items sold would have been assigned the following cost: ((200 units x $25) + (100 units x $24) + (400 units x $20)) = $15,400 COGS. The items in ending inventory would have been assigned the following cost: (300 units x $20) = $6,000 ending inventory.
- Using FIFO, the 700 items sold would have been assigned the following cost: ((200 units purchased previously x $20) + (500 units x $20) = $14,000 COGS. The items in ending inventory would have been assigned the following cost: ((100 units x $24) + (200 units x $25)) = $7,400 ending inventory.
- Using the weighted average cost method, every unit is assigned the same cost, the weighted average cost (WAC) per unit. To calculate the WAC per unit, we take the $21,400 total cost of all purchases and divide by the 1,000 total items (800 from current period purchases plus 200 from prior inventory). The WAC per unit is $21.40, so the COGS would be assigned a value of $14,980 (700 x $21.40) and ending inventory would be assigned $6,420 (300 x $21.40).
In each of these valuation methods, the sum of COGS and ending inventory remains the same. However, the portion of the total value allocated to each category changes based on the method chosen. A higher COGS leads to a lower net profit. Therefore, the method chosen to value inventory and COGS will directly impact profit on the income statement as well as common financial ratios derived from the balance sheet.