No matter the type of retail store or multi-channel e-commerce outlet that you have, you are going to come across ending inventory and the formula required to calculate it.
Working out how much saleable stock you have in the warehouse at the end of an accounting period can seem difficult, but reading this article should help you understand how to calculate it.
What is ending inventory?
Ending inventory is the value of the stock that you have in saleable condition at the end of an accounting period.
Inventory is shown as an asset on the balance sheet in accounting.
Therefore, this figure that you show will influence how much tax you pay and the company’s balance sheet so it has to be worked out correctly.
What is the basic ending inventory formula?
The formula used to calculate ending inventory is:
Inventory at the start + goods purchased – cost of goods sold = ending inventory.
- Inventory at the start = last accounting period’s ending inventory
- Goods purchased = items you have bought from suppliers.
What are the different ways of working out ending inventory
There are many different ways of working out ending inventory.
Which method you decide to use will affect many processes and procedures, including budgeting, reordering quantities and growth profit.
Take the time to choose the method that is best suited to your type of business and then stick with it.
FIFO method (first in/first out)
This method works on the basis that the inventory purchased first was sold. The cost of the stock purchased is added to the cost of goods sold.
As an example, imagine you purchase five items at £15 each and then a few months later, another five at £20.
Now you have ten items in stock and you sell just five of them. Using the FIFO method, you would sell the ones valued at £15 first, showing £150 as the cost of goods sold.
LIFO method (last in/first out)
This is the opposite of the method above. LIFO works on the principle that the goods purchased last are the ones sold.
Using the same example as above, imagine you purchase five items at £15 each and then a few months later, another five at £20.
Now you have ten items in stock and you sell just five of them. Using the LIFO method, you sell the items purchased last i.e. those valued at £20 each so the cost of goods sold equals £100.
Weighted average cost method (WAC)
The WAC takes the total amount you spent on inventory and divides it by the quantity.
This gives an average price for the cost of goods purchased.
Imagine you begin the accounting year with an inventory of 100 items priced at £2.50. You then buy 300 items at £3.50.
So inventory totals £250 plus £1050 giving a total of £1300. Divide this by 400 and you have £3.25, which is the weighted average.
This is the simplest way of valuing inventory and if your products in-store are the same, it works well.
£250 + £1050 = £1300 / 400 = £3.25
Gross profit method
The gross profit method can be used successfully when it's impossible to carry out a physical inventory.
Use this for periods in between physical counts or when inventory has been lost due to fire or theft. Insurers often use this method.
Don’t use this method to calculate your inventory at year-end, nor in your annual accounts for tax purposes.
The gross profit method works like this:
- Add the cost of your inventory at the start to the cost of goods purchased during the applicable period – this gives the total cost of goods for sale.
- Now take the anticipated gross profit percentage of the total sales figure during the same period – this gives the cost of goods sold.
- Finally, work out the approximate cost of goods available for sale minus the approximate cost of goods sold. This figure is your ending inventory.
An example would look like this:
Your store beginning inventory is £25,000 and you purchased £40,000 worth of goods. The cost of goods available for sale is, therefore, £65,000.
Your accountant has already told you that your gross margin percentage for the last year was 30% and he does not see this changing.
Sales during the same period were £70,000. The estimated cost of goods for sale is, therefore, £70,000 with a gross margin percentage of 30% = £21,000 cost of goods sold.
Now take the £65,000 goods available for sale minus £21,000 cost of goods sold to give a figure of £44,000, which is your ending inventory.
£25,000 + £40,000 = £65,000
30% of £70,000 = £21,000
£65,000 - £21,000 = £44,000
Problems with gross profit method
There are some problems associated with using this method.
It cannot be used for all annual reports as it only gives an estimate of the value of the ending inventory, not an actual figure.
The other problem is that it works with one overall gross profit percentage. This number is based upon historical data to date and is not a factual figure.
If prices drop or unforeseen events occur, the percentage could be very different, making the figures incorrect overall.
This method also does not take account of any losses due to theft or any other reason not factored into the historical gross profit percentage. Again, this can make the ending inventory figure inaccurate.
It is best to only use this method if the company involved is a retailer or e-commerce fulfilment store that purely buys and sells one type of product.
If the business is a manufacturer that buys goods in as components then such things as labour costs and overheads would need to be included, making the gross profit method unreliable.
If you do decide to use this technique, only do so for short periods. Using inventory management software with cycle inventory counts will help maintain an accurate inventory count which could help.
Retail inventory method
This method can be used when you need to estimate how much inventory you are holding.
It provides the ending inventory figure by calculating the cost of the inventory relative to the price of the stock. It does this by using the cost-to-retail ratio.
We recommend only using the retail inventory method when you have a distinct link between the price you buy from the wholesale supplier and the price you sell at to your customers.
As an example, if you have a store that sells candles and each one across the board is marked up at 100% from the purchase price, the retail inventory method will work well for you.
But if mark up on items vary i.e. some are 25%, others 30% and so on, this method can be hard to apply, as it won’t be so accurate.
You should know that when you apply the retail method to value your inventory, it could only ever provide an approximate stock value.
This is because some of the items in a retail store might have been damaged, stolen or lost. This is not such a problem for e-commerce fulfilment stores.
Because of this, if you have a retail store, you will need to carry out physical inventory checks routinely. This is the only way to be sure that your retail method is close to the real thing.
So how do you calculate ending inventory using the retail method?
The starting point is to total the number of goods that you have available for sale i.e. beginning inventory and any new items purchased.
You then subtract the sales for the same period from this figure. The difference is then multiplied by your percentage mark up to arrive at the total retail price.
This cost-to-retail ratio shows how much of the retail price is made up of costs. If one of the largest candles in your store costs £30 to buy from the supplier and sells for £60 then the cost-to-retail ratio is 50%.
(£30/£60) X 100 = 50%
Using the example above, the candle cost £30 and sold for £60 giving a cost-to-retail ratio of 50%. Now let’s imagine that the sales of that item totalled £6000 for the period:
Inventory at the start was £3000
New purchase were £300
This gives total goods for sale of £3300
Sales totalled £2400 (at 50% cost-to-retail ratio)
Ending inventory, therefore, equals £900
£3300 - £2400 = £900
However, some disadvantages come from using the retail inventory method. Whilst it is a very easy method to use, it can be inaccurate due to its simplicity:
- It can only ever provide an estimate so never expect the answer to tally with a physical count.
- It only works if the markup across all products is the same.
- When using this method, you are assuming that the same amount of markup percentage will be used going forward. If it changes for any reason (such as special offers or sales) then the results given by the calculation will no longer be accurate.
- The method won’t work if the goods purchased from the wholesale supplier or manufacturer were at a marked-down price.
Because there are so many ways of working out the ending inventory sum, it is best to find the one most suited to your business and then stick with it.
If you don’t do this and jump from one method to another, errors are sure to occur in the future.
Why is Ending Inventory Important?
Ending inventory is important because:
- It shows discrepancies between inventory matches your sales & purchases
- This may be required in an audit
- It helps with budgeting (as you can see if ending inventory tallies with your transactions)
- This can highlight issues with production costs.
We hope you have found this guide useful. If you are interested in taking your business to the next level, find out how Veeqo’s inventory management software could help you and your business.