What is Closing Stock?
Closing stock or inventory is the amount that a company still has on its hand at the end of a financial period. This inventory may include products that are getting processed or are produced but not sold. On a broad level, it includes raw material, work in progress, and finished goods—the units of closing stock help in determining the total amount.
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However, for a larger business, this is often impossible. Improvement in the inventory management software and other technologies are helping curb this problem.
Closing Stock Formula
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Below is the formula to calculate closing stock
Closing Stock Formula (Ending) = Opening Stock + Purchases – Cost of Goods Sold.
Top 4 Methods to Calculate Closing Stock
The method which company decides to use for pricing its closing stock will have a huge impact on its balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more and also on the income statement.
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The top 4 most common methods to calculate closing stock are as follows –
#1 First in first out (FIFO)
FIFO inventory methodFIFO Inventory MethodUnder the FIFO method of accounting inventory valuation, the goods that are purchased first are the first to be removed from the inventory account. As a result, leftover inventory at books is valued at the most recent price paid for the most recent stock of inventory. As a result, the inventory asset on the balance sheet is recorded at the most recent cost.read more assumes inventory which is brought first will be sold first, and the latest and the newest inventory is kept unsold. It means that the cost of older inventory is assigned to the cost of goods sold and the cost of the newer inventory is assigned to ending inventoryEnding InventoryThe ending inventory formula computes the total value of finished products remaining in stock at the end of an accounting period for sale. It is evaluated by deducting the cost of goods sold from the total of beginning inventory and purchases.read more
FIFO Example
- Beginning Inventory – 10 units @ $5 per unit
- Purchase – 140 units @ $6 per unit
- Sale – 100 units @ $5 per unit
Ending inventory – 10 + 140 – 100 = 50
Ending inventory amount ($) – 50 * $6 = $300
#2 Last in first out (LIFO)
LIFO Inventory MethodLIFO Inventory MethodLIFO (Last In First Out) is one accounting method for inventory valuation on the balance sheet. LIFO accounting means inventory acquired at last would be used up or sold first.read more assumes that the last item purchased will be sold off first. This method can be used for products which are not perishable or can be obsolete
LIFO Example
- Beginning Inventory – 10 units @ $5 per unit
- Purchase – 140 units @ $6 per unit
- Sale – 100 units @ $5 per unit
Ending Inventory – 40 + 10 = 50
Ending inventory amount ($) – 40 * $6 + 10 * $5 = $240 + $50 = $290
#3 Average cost method
Under this method, the weighted average cost is calculated for the closing stock. It is calculated as – cost of goods in inventory/total units
Average Cost Example
- Beginning Inventory – 10 units @ $5 per unit
- Purchase – 140 units @ $6 per unit
- Sale – 100 units @ $5 per unit
Weighted average cost per unit – (10 * 5 + 140 * 6)/150 = $5.9
Closing stock amount ($) – 50 * $5.9 = $295
#4 Gross profit method
Gross Profit method is also used to estimate the amount of closing stock.
- Step 1 – Add the cost of beginning inventory. The cost of purchases we will arrive at the cost of goods available for sale.
- Step 2 – Multiply (1 – expected gross profit) with sales to arrive at the cost of goods sold
- Step 3 – Calculate Closing Stock – To arrive at this amount, we will have to subtract the estimated cost of goods in step two from the cost of goods available for saleThe Cost Of Goods Available For SaleThe cost of goods available for sale refers to the cost of total goods produced during the year after accounting for the cost of finished goods inventory at the beginning of the year and is available for sale to the end-users.read more in step one.
Gross Profit Method Example
- Beginning Inventory – 10 units @ $5 per unit
- Purchase – 140 units @ $6 per unit
- Sale – 100 units @ $5 per unit
- Cost of Goods Available for Sale = 10 x 50 + 140 x 6 = 940
- Expected Profit marginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more = 40%
Sales = 100 x 5 = 500
Cost of Goods SoldCost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company.read more = 500 x (1-40%) = 300
Closing Stock ($) = 940 – 300 = 640
The drawback of this method is that the estimation of gross profit in step 2, base on the historical estimate, which may not necessarily be the case in the future. Also, if there are any inventory losses in that period are higher or lower than the historical rates, it can lead to an inappropriate amount of closing inventory.
Impact of Pricing Method on Closing Stock
The method by which a company decides to price its inflation affects its financial position and profits. If the company decides to use LIFO, then the cost of goods sold will be higher (assuming inflation is increasing), which reduces the gross profitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more and thus reduces the taxes. It is one of the vital reasons company’s prefer LIFO accounting over FIFO. One more valid reason is that on using FIFO, the amount of closing stock in the balance sheet will be higher in comparison to FIFO.
Ratios are also affected by the method in which inventory is used. The current ratioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities read more calculated as current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more/ current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc.read more will be higher when FIFO is used. Ending stock will increase the number of Current Assets. On the other hand, the inventory turnover ratioInventory Turnover RatioInventory Turnover Ratio is a measure to determine the efficiency of a Company concerning its overall inventory management. To calculate the ratio, divide the cost of goods sold by the gross inventory. read more calculated as Sales / Average inventory will be lower if FIFO is used.
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