Inventory and Cost of Goods Sold (Explanation Part 1)

Introduction to Inventory and Cost of Goods Sold

Inventory is a key current asset for retailers, distributors, and manufacturers. Inventory consists of goods (products, merchandise) awaiting to be sold to customers as well as a manufacturer’s raw materials and work-in-process that will become finished goods. Inventory is recorded and reported on a company’s balance sheet at its cost.

When an inventory item is sold, the item’s cost is removed from inventory and the cost is reported on the company’s income statement as the cost of goods sold. Cost of goods sold is likely the largest expense reported on the income statement. When the cost of goods sold is subtracted from sales, the remainder is the company’s gross profit.

It is critical that the items in inventory get sold relatively quickly at a price larger than its cost. Without sales the company’s cash remains in inventory and unavailable to pay the company’s expenses such as wages, salaries, rent, advertising, etc.

It is common for a company to experience rising costs for the goods it purchases. As a result, the company’s costs may be different for the same products purchased during its accounting year. When this occurs, the company must decide which costs should be matched with its sales and which costs should remain in inventory. In the U.S., three of the cost flow methods for removing costs from inventory and reporting them as the cost of goods sold include:

• FIFO or first in, first out. This cost flow removes the oldest inventory costs and reports them as the cost of goods sold on the income statement, while the most recent costs remain in inventory.

• LIFO or last in, first out. This cost flow removes the most recent inventory costs and reports them as the cost of goods sold on the income statement, and the oldest costs remain in inventory.

• Weighted average. This method calculates an average per unit cost and applies it to both the units in inventory and to the units sold.

In addition to selecting a cost flow method, the company selects one of the following inventory systems for recording amounts in its general ledger Inventory account(s):

• The periodic system indicates that the Inventory account will be updated periodically, such as on the last day of the accounting year. Throughout the year, the goods purchased will be recorded in temporary general ledger accounts entitled Purchases. At the end of the year, the cost of the ending inventory will be calculated. The Inventory account balance will be adjusted to this amount. At this time, the cost of goods sold is also calculated.

• The perpetual system indicates that the Inventory account will be continuously or perpetually updated. In other words, the balance in the Inventory account will be increased by the costs of the goods purchased, and will be decreased by the cost of the goods sold. Hence, the balance in the Inventory account should reflect the cost of the inventory items currently on hand. However, companies should count the actual goods on hand (take a physical inventory) at least once a year and adjust the perpetual records if necessary.

It is time consuming and costly for companies to physically count the items in inventory, determine their unit costs, and calculate the total cost in inventory. There may also be times when it is necessary to determine the cost of inventory that was destroyed by fire or stolen. To solve these problems, accountants often use the gross profit method for estimating the cost of a company’s ending inventory.

We will illustrate the FIFO, LIFO, and weighted-average cost flows along with the periodic and perpetual inventory systems. This will be done with simple, easy-to-understand, instructive examples involving a hypothetical retailer Corner Bookstore.

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Inventory Is Reported at Cost

Inventory items are recorded at their cost. Cost is defined as all costs necessary to get the goods in place and ready for sale. For instance, if a bookstore purchases a college textbook from a publisher for $80 and pays $5 to get the book delivered to its store, the bookstore will record the cost of $85 in its Inventory account. The recorded cost will not be increased even if the publisher announces that additional copies will cost $100.

When the textbook is sold, the bookstore removes the cost of $85 from its inventory and reports the $85 as the cost of goods sold on the income statement that reports the sale of the textbook.

The recorded cost for the goods remaining in inventory at the end of the accounting year are reported as a current asset on the company’s balance sheet.

Periodic vs Perpetual Inventory Systems

Each cost flow assumptions can be used in either of the following inventory systems:

• Periodic
• Perpetual

Under the periodic inventory system:

• The amount appearing in the general ledger Inventory account is not updated when purchases of merchandise are made from suppliers or when goods are sold.

• The Inventory account is normally adjusted only at the end of the year. During the year the Inventory account will show only the cost of inventory as of the end of the previous year.

• Purchases of merchandise are recorded in one or more Purchases accounts.

• At the end of the year the Purchases account(s) are closed and the Inventory account is adjusted to the cost of the merchandise actually on hand at the end of the current year.

• There is no Cost of Goods Sold account to be updated when a sale of merchandise occurs.

• There is no way to tell from the general ledger accounts the cost of the current inventory or the cost of goods sold.

Under the perpetual inventory system:

• The Inventory account is continuously updated.

• It is increased with the cost of merchandise purchased from suppliers.

• It is reduced by the cost of merchandise that has been sold to customers.

• The Purchases account(s) are not used in the perpetual inventory system.

• There is a general ledger account Cost of Goods Sold that is debited at the time of each sale for the cost of the merchandise that was sold.

• A sale of goods will result in a journal entry to record the amount of the sale and the cash received or the recording of accounts receivable.

• A second journal entry reduces the account Inventory and increases the account Cost of Goods Sold.