Why calculating ending inventory is necessary.

Calculating ending inventory is vital to know how much you are selling and for how much. It is also a key aspect of the accounting process because it directly affects your balance sheet and tax burden. Here are some reasons why getting your ending inventory valuations right is essential:

• Verifies recorded inventory matches, actual physical inventory counts
• Highlights inventory shrinkage issues due to human error, theft, or other reasons.
• Reveals how much revenue you are making on what you are selling.
• Minimizes overstock by providing accurate inventory counts.
• Delivers excellent insight and control over stock-related and financial decisions
• Impacts gross and net profits as well as tax liabilities.
• Allows investors and financial institutions to evaluate for funding events
• Selecting the best method and staying consistent with that method will provide insight into the health and profitability of the company.

Selecting the best method to calculate your ending inventory and staying with that method is imperative to minimize accounting errors and meet company needs. The choice can affect the stated value of the company’s assets, profit, and tax liability. Before filing your income or end-of-year taxes, it is necessary to calculate your ending inventory correctly.

FIFO method (first in, first out)

FIFO is a valuation method that assumes the first purchased inventory was sold first. The COGS (cost of goods sold during the period) is based on the stock bought earliest in the accounting period. This approach is suitable for many companies because it follows common operations strategies where older items are sold to make room for newer goods. This method is commonly used during an inflationary period. However, it can produce lower COGS and higher gross profits. This calculation often results in higher income tax burdens for the period.

LIFO method (last in, first out)

LIFO is another valuation method that assumes the most recently purchased goods are the first to be sold. This method closely reflects the actual cost of replacing the current inventory. It is typically used during periods of increasing prices. Companies can report higher COGS and lower gross profits, reducing the tax liability during the period. A significant drawback of this method is that it is rarely accepted outside of the US because it is not allowed under International Financial Reporting Standards (IFRS).

WAC method (weighted average cost)

The weighted average cost method (WAC) is where a business average all inventory costs to calculate COGS and ending inventory. Calculate it by dividing the total amount you spent on your inventory by the total number of items.

Here is a simple example. Let’s say you started your fiscal year with an inventory balance of 1000 items at $3.00 each. You purchased an additional 500 items at $3.50 later in the accounting period. Your ending inventory would include 1500 items valued at $3.17 each, totaling $4,750.

This method is the simplest way to evaluate ending inventory; it is best suited for companies that sell similar products. As businesses expand their product offering, calculating ending inventory becomes more complex.

Gross profit method

The gross profit method estimates ending inventory where an actual physical count is not desired or necessary. This method uses the company’s expected gross profit margin for the current period as a starting point for estimating COGS and ending inventory. Companies will use their historical gross profit margin as a guideline for their current expected gross margin. Keep in mind that this method is not acceptable for audited financial statements.

Here are the steps to calculate gross profit:

1. Multiply the net sales during the current period by (1 – expected gross profit margin) to obtain an estimate of COGS.
2. Apply the standard inventory valuation formula: Add up the period’s beginning inventory and the cost of all further inventory purchases to date. Then, subtract the estimated COGS to obtain the ending inventory.

Retail method

This method is best for retail stores looking to estimate inventory counts for a specific timeframe without doing a physical count. It uses the cost-to-retail ratio.

Total Cost Of Goods For Sale / Retail Value Of Those Goods = Cost-To-Retail Ratio

Once you have the cost-to-retail ratio, you multiply this number by the net sales for the period to estimate COGS. Then you plug this amount into the standing ending inventory formula listed above. This is an imprecise count but is helpful to assess ending inventory until a more accurate method can be performed for accounting and tax purposes.