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 determined as follows.
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
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:
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:
|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:
|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.
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 closing inventory is 5,000, then the journals would be:
|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.
|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:
|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.
- Gross profit method
- 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
and rearranging this we can get the ending inventory equation
If the purchases were 14,000 and the beginning inventory was 2,000, we can estimate the ending inventory as
Ending inventory = Purchases + Beginning inventory - Cost of goods sold Ending inventory = 14,000 + 2,000 - 12,000 = 4,000
Using this information the business would then post the inventory journals as before
|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.
|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.
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.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.