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 which 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.
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
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 sheet and also on the income statement.
The top 4 most common methods to calculate closing stock are as follows –
#1 First in first out (FIFO)
FIFO method assumes inventory which is brought first will be sold first and the latest and the newest inventory is kept unsold. This 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 inventory
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 Method 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 and 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 sale in step one
Gross Profit Method Example
- Beginning Inventory – 10 units @ $5 per unit
- Purchase – 140 units @ $6 per unit
- Sale – 100 units @ $5 per unit
- Cost of Goods Available for Sale = 10 x 50 + 140 x 6 = 940
- Expected Profit margin = 40%
Sales = 100 x 5 = 500
Cost of Goods Sold = 500 x (1-40%) = 300
Closing Stock ($) = 940 – 300 = 640
The drawback of this method is that the gross profit estimated in step two is based 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 in 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 profit and thus reduces the taxes. This is one of the vital reasons company’s prefer LIFO accounting over FIFO. One more valid reason is that if FIFO is used 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 ratio calculated as current assets/ current liabilities will be higher when FIFO is used. Ending stock will increase the number of Current Assets. On the other hand, the inventory turnover ratio calculated as Sales / Average inventory will be lower if FIFO is used.
Recommended Articles
This has been a guide to What is Closing Stock? Here we look at its formula, top 4 methods to calculate closing stock (LIFO, FIFO, Average Cost, Profit Margin) along with its impact on the financial statements. You may learn more about accounting basics from the following articles –
