As you manage your bookkeeping, you'll want to keep track of the inventory you have available and the value it offers your company. As a part of this tracking system, you'll need to note your ending inventory. Ending inventory is the amount of unsold inventory available at the end of an accounting period. On your balance sheet, you will note your ending inventory as a current asset. Additionally, changes in inventory are used to calculate the cost of goods sold (COGS), which is often reported on an income statement.
There are a couple of strategies to calculate the value of your ending inventory. Although the number of physical products available will remain consistent, the value you assign can change depending on the type of valuation you use.
To help you better manage your inventory, we'll walk you through what ending inventory is, its importance, and how you can calculate it.
What Are the 4 Inventory Types?
Inventory describes the products you sell to customers. Typically, as you determine your inventory balance, you will look at four main inventory types. These provide more information about how much you have available in different phases of production.
Raw materials describe the parts you need to produce your finished product. Depending on what you produce, this might include leather, cotton, paper, or wood.
Tracking your raw materials is important because it allows you to see your capacity for continuing to produce your products. Running out of raw materials can hinder your business's progress; you need to keep a solid ratio of raw materials to finished inventory to keep your business healthy.
Unfinished products refer to those that have gone through the manufacturing process but still have to go through some type of preparation before they can go to customers. These products have returned to your warehouse or another method of storage, but you still need to go through some last-minute details before you list them as ready for sale.
In-transit inventory is the classification you will use for inventory that your business has but is not actively in your possession. For example, you have products being shipped from a factory to your warehouse or store.
The best method to track inventory in transit is automation when possible. Having a system that scans items when they leave one of your buildings and when they arrive can help you track items when a physical count of inventory items is a challenge. If you don't have the capacity to do this, careful notes about items leaving one location until they arrive at another can help.
Finally, businesses need to track their cycle inventory. This inventory is that which businesses receive and then can quickly sell to customers. This type of inventory doesn't require as much investment in maintaining or storing before it moves on to customers. Quick procedures that allow your organization to quickly receive, process, and sell these products remain essential to successfully managing this type of inventory.
What Is LIFO and FIFO?
LIFO and FIFO are two inventory management systems that allow businesses to provide an estimated accounting of the cost of goods sold (COGS). In addition to understanding the different types of inventory that your business has, you also need to calculate their likely value so that you can use that in your calculations. LIFO stands for "last in, first out," while FIFO stands for "first in, first out."
Each method uses a slightly different system for assessing the value of the business's goods. Therefore, organizations may end up with slightly different total amounts for their accounting books. There is a third inventory valuation method, known as the weighted average, which uses the average of the inventory available for sale. This method doesn't have the same level of utilization as the other methods, so we won't include the average cost strategy here.
LIFO Inventory Method
The LIFO method means that businesses account first for their most recent inventory costs. This can result in some confusing calculations because businesses find that the cost to procure raw materials and produce goods goes up over time. This means that the cost to produce the earliest goods was likely lower than the cost to produce the most recent goods.
However, since businesses manage the higher, more recent costs first, it often shows lower profits. This generally results in lower taxes, which companies appreciate. However, lower profits might make it harder to demonstrate value or attract investors.
It's important to note that the LIFO method is accepted by generally accepted accounting principles (GAAP) in the United States. However, it's prohibited under the International Financial Reporting Standards (IFRS).
FIFO Inventory Method
The FIFO inventory method calls for businesses to use the costs associated with the earliest products first, moving forward to the most recent products. This also mimics the natural flow of buying and selling products, which many small business owners find makes it easier to manage.
This particular method will likely demonstrate the highest profit margins, as it will acutely reflect the changing costs of purchases for raw materials and manufacturing. While this will typically result in greater taxes for businesses, it also presents the most favorable possible picture to investors and others interested in the business's growth. Many consider the FIFO inventory method an industry best practice.
Why Is Ending Inventory Important?
Businesses want to know the amount of inventory available at the end of each accounting period so that they have an accurate picture of their success during that specific period. Inventory is a valuable asset, as its sale generates profits and revenue.
Therefore, knowing how much inventory is available at the end of the accounting period can help businesses record their products ready for sale, better calculate their net income, and track their inventory reports so that they can feel confident in their accuracy.
How to Calculate Ending Inventory
To calculate your ending inventory, you will need to bring together a few key pieces of information:
- Beginning inventory
- Net purchases
Together, you will use this information to produce the following ending inventory formula.
|+ Net Purchases|
|= Ending Inventory|
We'll walk you through each part of the equation to help you calculate your ending inventory balance.
Determine Which Inventory Method to Use
Before you get started with your ending inventory value, you'll need to determine whether you will use the FIFO method or the LIFO method for calculating your COGS.
Determine Beginning Inventory
Next, you'll need to determine your beginning inventory count. Your beginning inventory is the value of the inventory you started the accounting period with. You can find this information by looking at your financial statements from the previous accounting period.
Determine Total Net Purchases
Your total net purchases reflect the total cost of your inventory purchases during this period. You'll want to take out any discounts you received on these purchases and any returns you made so that this number reflects how much you spent on inventory during this period.
Determine Cost of Goods Sold (COGS)
The COGS reflects the inventory accounting method of valuation that you selected earlier (LIFO or FIFO). You'll look at the number of products you sold and then multiply that by the cost of the goods. If you selected the LIFO system, you'll start with the most recent costs first and work backward. If you select FIFO, you'll start with the oldest product costs and work forward.
Calculate Ending Inventory
Now that you have all the information you need, you'll want to run through the calculation. We'll walk you through an example:
Let's say that Jan owns a store where she sells computers. When she started this accounting period, she had $100,000 worth of inventory. She also made $20,000 worth of purchases during this period.
Her most recent purchases followed this chart:
|Month||Number of Units||Cost per Unit|
If she sold 125 units and uses the FIFO method, she will tally her costs as:
- 100 units x $300
- 25 units x $350
This will give her a total COGS of $38,750
However, if she uses the LIFO method, she will tally her costs as:
- 50 units x $400
- 50 units x $350
- 25 units x $300
This will give her a total COGS of $45,000.
Therefore, Jan's ending inventory will be calculated as:
|− $38,750 (or $45,000)|
|= $81,250 (OR $75,000)|
Let Skynova Help You Manage Your Small Business Accounting
As you work to track your ending inventory and the rest of your accounting needs, Skynova is here to help. With business templates to help manage everything from creating estimates to invoicing customers and accounting software designed to keep your bookkeeping simple to manage, you can focus on what matters most to you: running your business.
See how Skynova's software products can help you today.
Notice to the Reader
The content within this article is meant to be used as general guidelines regarding inventory and accounting and may not apply to your specific situation. Always consult with a professional accountant to ensure you're meeting accounting standards.