CLOSING STOCK – DEFINITION, CALCULATION, FORMULA AND EXAMPLES

Closing stock is the quantity of inventory that a firm has at the end of a financial period. Inventory can be raw materials, work-in-process, or finished goods. You may understand it as an amount of unsold stock lying in a business on a specific date. You can calculate closing stock using this formula: Closing stock= (Opening Stock + Inward)- Outward.

The closing stock also helps in deciding the total amount of the inventory. In accounting, the closing stock is treated as an asset as it’s displayed on the asset side of the balance sheet. If there is an increase in the closing inventory at the end of the reporting period, this results in the deduction of the cost of goods sold (COGS), which ultimately increases gross profit. It helps assess the inventory situation, which is crucial for the manufacturing business.

What is Closing Stock?

Definition: The closing stock is the total of unsold stock at the end of the financial/reporting year. Hence, a closing stock account is associated with an inventory that hasn’t been sold yet. It includes raw materials, finished goods, and work-in-process. A closing stock value is decided as per the cost or market rule and therefore, a stock will be valued at cost or market price, whichever is less.

Closing stock being an asset of the firm is debited in a journal entry and credited to the trading account. The closing stock amount can be found through a physical count of the inventory, plus its calculation can also be done using a perpetual inventory system and cycle counting for regularly adjusting inventory records to arrive at the ending balances.

What is a Closing Stock Comprised of?

The closing stock comprises three types of materials:

1. Raw material

This is the material that a company needs to manufacture its finished goods. Raw material includes steel, oil, plastic, etc. There are three kinds of costs associated with raw material: COGS (Cost Of Goods Sold), labor expenses, and amortization expenses. Raw materials are recorded as an asset on the balance sheet.

2. Work-in-progress

This refers to the materials which are being fabricated into final products (partially finished goods). It is also known as work-in-process.

3. Finished Products

Finished goods are the goods that have completed the manufacturing process and are ready to be sold to the customers.

Closing Stock Formula

The formula to find the closing stock:

Closing stock = (Opening Stock + Inward) – Outward

or

Closing stock = Opening Stock + Purchases – Cost of Goods Sold.

In the formula, Opening stock means unsold goods that are being carried forward from the previous year, while purchases refer to the new stock purchased by the company.

How to Calculate Closing Stock

There are various methods to calculate the value of the closing stock:

1. First In, First Out Method

Commonly known as FIFO, in this method, the assets produced or acquired first are sold or disposed of first. In an inflationary market, this typically results in a lower cost of goods sold, which results in higher profits. It is an incredibly easy method to apply & manipulation of income is not possible. However, sometimes it tends to overstate gross margins, especially during inflation, which leads to misleading financial statements. Let us understand this with an example below-

Opening Inventory- 20 units @ $10 per unit

Purchase- 280 units @ $3 per unit

Sale- 200 units @ $10 per unit

Ending inventory= 20 + 280 – 200= 100

Ending inventory amount ($)= 100 * $3 = $300

2. Last In, First Out Method

It’s the opposite of FIFO. Commonly known as LIFO, in this method, the assets produced or acquired last are sold or disposed of first. In simpler words, the cost of the most recent products purchased is first to be expensed. LIFO is operated only in the United States.

This method is generally used for products that are perishable or can be obsolete. LIFO is not advised above FIFO because it can understate the company’s earnings for tax evasion. Let us understand this with the following example-

Opening Inventory- 20 units @ $10 per unit

Purchase- 280 units @ $3 per unit

Sale- 200 units @ $10 per unit

Ending inventory= 80 + 20 = 100

Ending inventory amount ($)= 80 $3 + 20 $10 = $240 + $200 = $440

3. Retail Inventory Method

In this method, retailers assess their ending inventory based on the connection between the cost of the goods and their retail price.

This method is typically operated by retail businesses for accounting & management intents.

The retail inventory method is widely used and is acceptable for inventory valuation under GAAP (Generally Accepted Accounting Principles).

4. Weighted Average Method

In the weighted average method, the total cost of available goods is divided by the number of units available.

This method is one of the three main methods for inventory valuation, the other two being FIFO & LIFO. It results in a reasonable average cost of the goods irrespective of inflation.

5. Average cost method

With the help of this method, the weighted average cost can be calculated for the closing stock.

The formula to find out the weighted average cost-

Cost of goods in inventory/total units

6. Gross profit method

This method is used to estimate the total amount of closing stock. A few easy steps you need to follow for calculating it are-

1.    You need to add the cost of beginning inventory. You will arrive at the cost of purchases at the cost of goods available for sale

2.    Then in the second step, you should Multiply (1 – expected gross profit) with sales for arriving at the cost of goods sold

3.    In this step, you can calculate closing stock, and for this, you need to subtract the estimated cost of goods in step two from the cost of goods available for sale in step one

Impact of Pricing Method on Closing Stock

All the methods for inventory valuation are different, and they affect closing stock differently. The method by which a company chooses to price its inflation affects its profits.

In the case of FIFO, the amount of closing stock will be higher & the cost of goods sold will be lower. Meanwhile, under LIFO, the cost of goods sold is generally higher, which results in lower gross profit and thus reduces the taxes. It is why LIFO is banned under IFRS (International Finance Reporting Standards).

Ratios also get affected as per the method in which inventory is used. The current ratio determined by current assets/ current liabilities will be higher when FIFO is used. Ending stock here increases the number of current assets. In addition, the inventory turnover ratio determined as Sales / Average inventory will be lower in the case of FIFO.

Closing Stock in Balance Sheet

Closing stock is treated as an asset and shown on the asset side of the balance sheet. Afterward, it will be this is adjusted with the purchase amount that can be taken to the debit side of the trading account.

While the closing stock will appear on the asset side of the balance sheet. In some of the cases in the trial balance, the adjusted purchase will be given which would suggest that opening stock and closing stock can get adjusted through this purchase. Finally, the adjusted purchase account and closing stock account will appear in the trial balance.

Valuation of Closing Stock

For evaluating the closing stock, you need to add new purchases to the ending inventory, then you should minus the cost of goods sold. Closing stock is valued at cost price or market price, whichever is lower.

This will assist in finding out the final value of the inventory at the end of the accounting period. Ending inventory here will be based upon the market value or lowest value of the goods that a business is supposed to process.

One of the most obvious ways of calculating the closing inventory is through a physical count at the end of every month and then valuation of inventory takes place through the valuation methods like FIFO, LIFO, and the weighted average method. But, in general, it is not practical to do physical counting, and therefore, estimation methods are used to calculate the closing inventory. The two methods are used to evaluate the closing stock: Gross Profit Method & Retail Method

1. Using Gross Profit Method

This method is also used to determine the quantity of inventory that has been lost due to theft or fire.

The steps to use the gross profit method for inventory valuation:

1.    First, add the cost of the beginning inventory to the cost of purchases during the period.

2.    Then, multiply the gross profit percentage by the number of sales. The answer will be the cost of goods sold.

3.    Then, subtract the cost of goods available for the sale from the cost of goods sold to estimate the closing inventory.

2. Using the Retail Method

This method is primarily used by retailers. This method is helpful for the retailers as it helps them increase profits and track inventory effectively. Following are the steps to calculate:

1.    Estimating the cost to retail percentage. – Formula: Cost to retail percentage = Cost / Retail Price

2.    Estimating the cost of available goods. – Formula: Cost of Good Available for Sale = the cost of beginning inventory + the cost of purchases

3.    Estimating the cost of sale that occurred during the period. – Formula: Cost of Sales = Sales x Cost-To-Retail Percentage

4.    The formula for calculating ending inventory – Cost of goods available for sale – Cost of sales during the period.

There are various methods to use for valuing closing stocks. However, a company should choose the manner which aligns better with their needs.

Following are the methods to value closing stocks:

1.    Weighted Average Method

2.    Moving Average Method

3.    First In, First Out Method (FIFO)

4.    Last In, First Out Method (LIFO)

5.    Method of calculating costs

6.    At Zero Cost

All the methods are different & they have a direct effect on the business’ profits. Companies should select a process that is nicely fit for their products & nature of their business.

Conclusion!

Closing stock is an essential topic in accounting and critical to understanding for students or professionals. It helps in managing stocks, especially during the changing financial period.

As an integral component in accounting, closing stock helps in understanding the amount of unsold stock by a business. With its understanding, you can make relevant decisions about them that can be reflected in your business’s ledger. By using different calculation methods, you can find the closing stock of a business.

 marketing91