What it means
Every trading business begins a period with some stock, buys more during the period and sells some of it. What is left at the end is ending inventory, and it becomes the opening inventory for the next period.
The relationship between these amounts links the balance sheet and the income statement. The cost of goods sold is calculated by taking opening inventory, adding purchases and deducting ending inventory.
A higher ending inventory therefore means a lower cost of goods sold and a higher profit for the period, and a lower ending inventory has the opposite effect. This is why errors in counting or valuing stock directly distort profit.
Ending inventory is determined either by a physical count at the period end or by a continuous record system that updates with every movement. Many businesses use both, with a perpetual system for daily control and a physical count to confirm accuracy.
Differences are investigated and adjusted for losses, damage and theft. The cost attached to each item depends on the costing method chosen.
First in, first out assumes the oldest stock is sold first, so ending inventory is valued at the latest prices. Weighted average cost uses a blended price, and some countries also permit last in, first out, which values ending inventory at older prices.
Inventory must be valued at the lower of cost and net realisable value, which is the price the goods could be sold for less the costs of selling them. If goods have become damaged, obsolete or unsaleable, they are written down.
This stops the balance sheet from overstating the asset. Managers also watch ending inventory as a measure of efficiency.
Too much stock ties up cash and risks obsolescence, while too little risks lost sales and unhappy customers. Ratios such as inventory turnover show whether the balance is right.
In practice
Real-world examples
Example 1
A furniture shop starts the year with $200,000 of stock and buys $900,000 during the year. At the year-end count, stock on hand is valued at $250,000. The cost of goods sold is 200,000 + 900,000 - 250,000 = $850,000.
Example 2
A fashion retailer finds at the season's end that $60,000 of winter coats cannot be sold at full price. It writes them down to their expected selling price of $35,000, which reduces ending inventory by $25,000. The write-down is charged against profit in the same period.
Example 3
A manufacturer counts its ending inventory one week after the period end because of staff holidays. The finance manager adjusts the count for the week's movements, adding back sales and deducting purchases, so that the figure reflects the position at the period end.
Think of it
Ending inventory is what's left on the shelves at period end-your unsold goods.
Formula
Calculation
Ending inventory = Beginning inventory + Purchases - Cost of goods sold
Suppose a retailer begins the quarter with inventory of $120,000, buys a further $480,000 of goods during the quarter and records cost of goods sold of $450,000.
Ending inventory = 120,000 + 480,000 - 450,000 = $150,000.
Cost of goods sold can be found the other way round: 120,000 + 480,000 - 150,000 = $450,000, which confirms the result.
If the retailer's physical count found only $145,000 of stock on the shelves, the $5,000 difference would be investigated as possible shrinkage, damage or error.Case study
Seen in the real world
Oakley and Marsh Hardware is an illustrative, fictional retailer that reported record profit in a year when sales were flat. The owner was pleased but the accountant was suspicious.
A review found that the year-end stock count had been entered twice for one warehouse, overstating ending inventory by $90,000. With cost of goods sold understated by the same amount, profit had been overstated by $90,000.
After correcting the figure, the company introduced a count sheet control, with each area signed off by two people. The illustrative lesson is that ending inventory is one of the easiest numbers to get wrong, and one of the most powerful in its effect on profit.
Watch out
Common mistakes
- Counting stock twice or missing some locations, which misstates profit.
- Valuing obsolete or damaged goods at full cost instead of writing them down.
- Including goods that belong to others, such as items held on consignment, in the company's own inventory.
Questions
People also ask
Why does ending inventory affect profit?
It is deducted when working out the cost of goods sold, so a higher ending inventory lowers the cost of sales and raises profit.
What is the difference between ending inventory and closing stock?
They mean the same thing, as closing stock is the term commonly used in UK English.
How often should ending inventory be counted?
A full count is normally done at least once a year, and many businesses use regular cycle counts of different areas during the year.
Watch