Closing stock is the inventory at the end of an accounting period. It includes finished goods, raw materials and work-in-process, which is the stock of partially finished goods. The closing stock appears as inventory under assets on the balance sheet and is a component of the cost of goods calculation on the income statement. The closing stock can be estimated in several different ways.
Valuation: Gross Profit Method
The gross profit method uses the gross profit of the most recent accounting period to estimate the closing stock. For example, if last year’s gross profit margins were 60 percent and sales are $10,000 in the most recent accounting period, then the gross profit is $6,000 (60 percent times $10,000). If the beginning inventory was $5,000 and purchases were another $4,000, then total cost of goods available for sale was $9,000 ($5,000 plus $4,000). The cost of goods sold is equal to the sales minus the gross profit, or $4,000 ($10,000 minus $6,000). The ending inventory is equal to the cost of goods available minus the cost of goods sold, assuming that all items not sold remain in inventory and there is no loss due to theft or damage. To conclude the example, the closing stock using the gross profit method is $5,000 ($9,000 minus $4,000).
Valuation: Retail Method
The retail method of estimating the closing stock can be used by businesses that maintain inventory records in both cost and retail selling prices. For example, if you own a small retail business, you can get the goods available for sale, on both a cost and retail basis, by adding the beginning inventory to the purchases made during the accounting period. For example, if the goods available for sale on a cost and retail basis are $45,000 and $60,000, respectively, then the cost-to-retail ratio is 75 percent ($45,000 divided by $60,000). If your retail sales were $50,000 during the period, then the closing stock on a retail basis is $10,000 ($60,000 minus $50,000). The closing stock on a cost basis is the closing stock at retail multiplied by the cost-to-retail ratio. To conclude the example, the closing stock on a cost basis is $7,500 (75 percent times $10,000).
Other Valuation Methods
Other valuation methods include FIFO (first-in first-out) and LIFO (last-in first-out). In FIFO, the first product purchased is assumed to be the first one used, which usually means that the ending inventory valuation will be higher because prices tend to rise over time. In LIFO, the last product purchased is assumed to be the first one used, which leads to a lower ending inventory valuation because the recent -- and usually higher-priced -- items have been charged to cost of goods sold.
Considerations: Managing Stock Levels
Stock levels that are higher or lower than historical trends must be evaluated carefully. For example, if your closing stock is too low, there could be a problem with your suppliers not keeping pace with demand or it could be that demand itself has fallen off. If the closing stock is too high, you might be losing customers to your competition because of over-priced products or changing customer preferences.