How to estimate ending inventory
/What is Ending Inventory?
Ending inventory is the total unit quantity of inventory in stock or its total valuation at the end of an accounting period. The ending inventory figure is needed to derive the cost of goods sold, as well as the ending inventory balance to include in a company's balance sheet. For organizations dealing with large quantities of inventory, deriving the ending inventory figure could be the most important part of the process of closing the books.
Reasons for Estimating Ending Inventory
There are several good reasons why it is not possible to conduct a physical count of the ending inventory. This situation can arise when there is too much shipping activity at month-end to conduct a physical count, or because the counting process is too labor-intensive, or when the staff is too busy to take the time to conduct a physical count. These situations are especially common during the peak selling season of a business.
If so, there are two methods available for estimating the ending inventory, which are the gross profit method and the retail inventory method. These methods are not foolproof, since they rely upon historical trends, but they should yield a reasonably accurate number, as long as no unusual transactions occurred during the period that might alter the ending inventory.
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The Gross Profit Method
The first method for estimating ending inventory is the gross profit method. The basic steps are:
Add together the cost of beginning inventory and the cost of purchases during the period to arrive at the cost of goods available for sale.
Multiply (1 - expected gross profit %) by sales during the period to arrive at the estimated cost of goods sold.
Subtract the estimated cost of goods sold (step #2) from the cost of goods available for sale (step #1) to arrive at the ending inventory.
The trouble with the gross profit method is that the result is driven by the historical gross margin, which may not be the margin experienced in the most recent accounting period. Also, there may be inventory losses in the period that are higher or lower than the long-term historical rate, which can also vary the result from whatever the actual ending inventory may turn out to be.
The Retail Inventory Method
The retail inventory method is an alternative approach that is used by retailers to calculate their ending inventory. Rather than using the gross margin percentage as the foundation for the calculation, this method uses the proportion of the retail price to cost in prior periods. The calculation is:
Calculate the cost-to-retail percentage, for which the formula is (Cost / Retail price).
Calculate the cost of goods available for sale, for which the formula is (Cost of beginning inventory + Cost of purchases).
Calculate the cost of sales during the period, for which the formula is (Sales x cost-to-retail percentage).
Calculate ending inventory, for which the formula is (Cost of goods available for sale - Cost of sales during the period).
This method only works if you consistently mark up all products by the same percentage. Also, you need to have continued to use the same markup percentage in the current period (discounts for periodic sales can cause incorrect results). Thus, a series of discounts to clear out stock after the main selling season of the year can impact the outcome of this calculation.
The Need for Physical Counts
Note that the methods described here can only be used to estimate ending inventory - nothing beats a physical count or cycle counting program to obtain a much more accurate ending inventory valuation. Increased accuracy can also be obtained with a proper reserve for obsolete inventory and consideration of the effects of any inventory cost layering methodologies, such as the LIFO or FIFO methods.
A company that needs a precise ending inventory figure, as is common for audited financial statements or a pending acquisition, will probably need to complete a detailed physical inventory count, rather than using either of the estimation methods noted above.
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