How to Estimate Ending Inventory
Estimating ending inventory can be done using several accounting methods. Here are three common methods:
- Retail Inventory Method: This method requires you to maintain a consistent gross margin rate. The calculation involves converting the retail price of your inventory to a cost price by using this ratio. The steps are as follows:
- Calculate the cost-to-retail price ratio: (Cost of goods available for sale / Retail price of goods available for sale).
- Calculate total sales at retail prices.
- Subtract sales from the retail price of goods available for sale to get ending inventory at retail prices.
- Multiply ending inventory at retail prices by the cost-to-retail price ratio to get ending inventory at cost.
- Gross Profit Method: This method estimates ending inventory based on the historical gross profit rate. The steps are:
- Calculate your historical gross profit rate: (Historical Gross Profit / Historical Sales)
- Calculate your sales for the period.
- Multiply your sales for the period by your gross profit rate to estimate your cost of goods sold.
- Subtract the estimated cost of goods sold from the cost of goods available for sale to estimate your ending inventory.
- Average Cost Method: This method requires that you calculate an average cost for each item in your inventory and then multiply by the count of your remaining items. The steps are:
- Calculate the total cost of goods available for sale.
- Count the total number of items available for sale.
- Divide the total cost by the total number of items to get the average cost per item.
- Count the number of items remaining in inventory.
- Multiply the average cost per item by the number of items remaining to estimate your ending inventory.
It’s important to remember that these are estimates. They can provide a reasonable approximation of ending inventory, but they may not be entirely accurate. A physical count of inventory is typically needed for more precise numbers. Each method has its advantages and disadvantages, and the best method to use depends on the specific circumstances of your business.
Please note that these methods should be used consistently and in accordance with accounting standards and principles. Always consult with an accountant or finance professional when dealing with financial estimates and reporting.
Example of How to Estimate Ending Inventory
Let’s go through an example using each of the three methods.
Consider a hypothetical company, Crafted Tables Co., that started the year with an inventory of $100,000 (at cost). During the year, the company purchased an additional $400,000 of inventory. The sales for the year totaled $600,000. Let’s assume a gross profit rate of 40% for the Gross Profit Method.
- Retail Inventory Method:
For this example, we’ll also need the retail prices. Let’s say the retail price of goods available for sale was $750,000.- Cost-to-Retail Price Ratio = ($100,000 beginning inventory + $400,000 purchases) / $750,000 = $500,000 / $750,000 = 0.67
- Total sales at retail prices are $600,000.
- Ending inventory at retail prices = $750,000 – $600,000 = $150,000.
- Estimated Ending Inventory = $150,000 * 0.67 = $100,500.
- Gross Profit Method:
- Gross Profit Rate = 40% (Given)
- Sales for the period = $600,000.
- Estimated Cost of Goods Sold = $600,000 * (1 – 0.4) = $360,000.
- Estimated Ending Inventory = ($100,000 beginning inventory + $400,000 purchases) – $360,000 = $140,000.
- Average Cost Method:
For this example, we’ll need the total number of tables sold and left in the inventory. Let’s say the company started with 1000 tables, purchased an additional 4000 tables during the year, and sold 4500 tables.- Average Cost per Item = $500,000 / 5000 = $100.
- Count of remaining tables = 500.
- Estimated Ending Inventory = $100 * 500 = $50,000.
These calculations demonstrate how different methods can lead to different estimates for ending inventory. Each method has its own advantages and disadvantages, and the best method to use depends on the nature of your business and your specific circumstances.
