Ending Inventory

Ending Inventory and Cost of Goods Sold

At the month end a business needs to be able to calculate how much profit it has made. In order to be able to do this, the accounting records are closed, the temporary income and expenses accounts balances are transferred to the income statement, and an adjustment is made for the ending inventory.

Part of that income statement is the calculation of gross profit, which is

Gross profit = Sales – Cost of goods sold

However, there is a problem. When the purchases account is closed and transferred to the income statement, its balance represents the amount of goods purchased during the period, and not the cost of the goods sold during the period, which is required to calculate gross profit.

How do we convert our Purchases into Cost of goods sold?

The problem is solved by using the adjusting for inventory.

If a business has goods available for sale and it knows the cost of the goods not sold, then it can work out the cost of the goods sold

Cost of goods sold = Cost of goods available for sale – Cost of goods not sold

If we have a new business with no beginning inventory, then the goods available for sale must be the purchases, and the cost of goods not sold is the ending inventory, so we have the cost of goods equation:

Cost of goods sold = Purchases – Ending inventory

To correct the cost of goods sold in the income statement we simply need to reduce the purchases by the ending inventory. Assuming for example, the business has purchases of 10,000 and the ending inventory is 2,000, then the journal would be:

Inventory journal entry
Account Debit Credit
Inventory account 2,000
Cost of goods sold account 2,000

The business now has an ending inventory in its balance sheet of 2,000, representing the goods not sold, and the income statement is showing the cost of goods sold as:

Extract from the income statement
Purchases 10,000
Ending inventory -2,000
Cost of goods sold 8,000

Beginning and Ending Inventory

If the business now moves into its next accounting period, it has beginning inventory of 2,000 (last months ending inventory). This time the goods available for sale are the purchases plus the beginning inventory, and as before, the cost of the goods not sold is the ending inventory.

Cost of goods sold = Purchases + Beginning inventory – Ending inventory

To correct the cost of goods sold in the income statement we  need to increase the purchases by the beginning inventory and as before reduce the purchases by the ending inventory. Assuming for example, the business has beginning inventory of 2,000, purchases of 14,000 and the ending inventory is 5,000, then the journals would be:

Beginning inventory journal entry
Account Debit Credit
Inventory account 2,000
Cost of goods sold account 2,000

This journal increases the purchases by the beginning inventory and at the same time reduces the inventory account to zero. This is followed by the ending inventory journal.

Ending inventory journal entry
Account Debit Credit
Inventory account 5,000
Cost of goods sold account 5,000

Following this journal, the business has an inventory in its balance sheet of 5,000, representing the goods not sold, and the income statement is showing the cost of goods sold as:

Extract from the income statement
Beginning inventory 2,000
Purchases 14,000
Ending inventory -5,000
Cost of goods sold 11,000

How do you know the Cost of Ending Inventory?

In order to prepare the ending inventory journals and calculate the cost of goods sold, the business needs to know the cost of its ending inventory (it will know its beginning inventory from the previous period calculations).

The obvious method of finding the ending inventory is for the business to carry out a physical inventory count at the end of each month, and then to value its inventory using the appropriate Average, LIFO or FIFO method. However, it is not always practical to carry out a physical count and an estimation method is often used.

Closing Inventory Calculation Methods

In the absence of a physical inventory count, there are two standard methods for estimating the closing inventory.

  1. Gross profit method
  2. Retail method

Gross Profit Method

Assuming that the business has been trading for some time, it is usual for the gross margins to be relatively stable. If this is the case then the cost of goods sold can be estimated by applying the gross margin to the revenue for the period.

Suppose for example the revenue for the month is 20,000 and the gross margin of the business is normally stable at around 60%, we can then estimate the cost of goods sold as:

Cost of goods sold = Revenue x Gross margin
Cost of goods sold = 20,000 x 60% = 12,000

Now we know that

Cost of goods sold = Purchases + Beginning inventory – Ending inventory

and rearranging this we can get the ending inventory equation

Ending inventory = Purchases + Beginning inventory – Cost of goods sold

If the purchases were 14,000 and the beginning inventory was 2,000, we can estimate the ending inventory as

Ending inventory = 14,000 + 2,000 – 12,000 = 4,000

Inventory Journals

Using this information the business would then post the inventory journals as before

Inventory journal entry
Account Debit Credit
Inventory account 4,000
Cost of goods sold account 4,000

The business now has an ending inventory of 4,000 in its balance sheet. Providing the business is comfortable that its gross margin estimate is reasonably accurate, this process can continue until the business is in a position to carry out a physical inventory count. (this should be sooner rather than later to avoid nasty surprises).

When the physical count is carried out, an accurate value of the ending inventory is obtained, and an adjusting entry can be made to correct the inventory account.

Suppose in the example above a stock-take revealed that the inventory was in fact 5,000, then the correcting journal would be.

Inventory journal entry
Account Debit Credit
Inventory account 1,000
Cost of goods sold account 1,000

The cost of goods sold has been reduced by 1,000 and the balance sheet inventory account will now show an final closing inventory of 4,000 plus 1,000 equal to 5,000.

Retail Method

The retail method is primarily used by retailers who maintain records of inventory at retail value. The retail method involves using the beginning inventory and purchases to calculate a cost to retail ratio, and then applying this to the closing inventory at retail value, to give an estimate of the closing inventory at cost.

Our retail inventory method tutorial provides further detail on the application and use of this method.

Ending Inventory March 31st, 2017Team

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