Introduction to Inventory and Cost of Goods Sold

Inventory is merchandise purchased by merchandisers (retailers, wholesalers, distributors) for the

purpose of being sold to customers. The cost of the merchandise purchased but not yet sold is reported in
the account Inventory or Merchandise Inventory.

Inventory is reported as a current asset on the company's balance sheet. Inventory is a significant asset
that needs to be monitored closely. Too much inventory can result in cash flow problems, additional
expenses (e.g., storage, insurance), and losses if the items become obsolete. Too little inventory can
result in lost sales and lost customers.

Because of the cost principle, inventory is reported on the balance sheet at the amount paid to obtain
(purchase) the merchandise, not at its selling price.

Inventory is also a significant asset of manufacturers. However, in order to simplify our explanation, we
will focus on a retailer.

Cost of Goods Sold

Cost of goods sold is the cost of the merchandise that was sold to customers. The cost of goods sold is
reported on the income statement when the sales revenues of the goods sold are reported.

A retailer's cost of goods sold includes the cost from its supplier plus any additional costs necessary to
get the merchandise into inventory and ready for sale. For example, let's assume that Corner Shelf
Bookstore purchases a college textbook from a publisher. If Corner Shelf's cost from the publisher is $80
for the textbook plus $5 in shipping costs, Corner Shelf reports $85 in its Inventory account until the book
is sold. When the book is sold, the $85 is removed from inventory and is reported as cost of goods sold
on the income statement.

When Costs Change

If the publisher increases the selling prices of its books, the bookstore will have a higher cost for the next
book it purchases from the publisher. Any books in the bookstore's inventory will continue to be reported
at their cost when purchased. For example, if the Corner Shelf Bookstore has on its shelf a book that had
a cost of $85, Corner Shelf will continue to report the cost of that one book at its actual cost of $85 even if
the same book now has a cost of $90. The cost principle will not allow an amount higher than cost to be
included in inventory.

Let's assume the Corner Shelf Bookstore had one book in inventory at the start of the year 2010 and at
different times during 2010 purchased four identical books. During the year 2010 the cost of these books
increased due to a paper shortage. The following chart shows the costs of the five books that have to be
accounted for. It also assumes that none of the books has been sold as of December 31, 2010.
 Cost
Number Total
per
of Books Cost
Book
Inventory at Dec. 31, 2009 1 @ $85 = $ 85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 = 90
Total goods available for sale 5 $440
Less: Inventory at Dec. 31, 2010 5 440
Cost of goods sold 0 $0

Cost Flow Assumptions

If the Corner Shelf Bookstore sells only one of the five books, which cost should Corner Shelf report as
the cost of goods sold? Should it select $85, $87, $89, $89, $90, or an average of the five amounts? A
related question is which cost should Corner Shelf report as inventory on its balance sheet for the four
books that have not been sold?

Accounting rules allow the bookstore to move the cost from inventory to the cost of goods sold by using
one of three cost flows:

1. First In, First Out (FIFO)

2. Last In, First Out (LIFO)
3. Average

Note that these are cost flow assumptions. This means that the order in which costs are removed from
inventory can be different from the order in which the goods are physically removed from inventory. In
other words, Corner Shelf could sell the book that was on hand at December 31, 2009 but could remove
from inventory the $90 cost of the book purchased in December 2010 (if it elects the LIFO cost flow
assumption).

Inventory Systems

Each of the three cost flow assumptions listed above can be used in either of two systems (or methods) of
inventory:
A. Periodic
B. Perpetual

A. Periodic inventory system. Under this system the amount appearing in the Inventory account is not
updated when purchases of merchandise are made from suppliers. Rather, the Inventory account is
commonly updated or adjusted only once—at the end of the year. During the year the Inventory account
will likely show only the cost of inventory at the end of the previous year.

Under the periodic inventory system, 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 equal the cost of the merchandise actually on hand at the end of the year. Under the periodic
system there is no Cost of Goods Sold account to be updated when a sale of merchandise occurs.

In short, under the periodic inventory system there is no way to tell from the general ledger accounts the
amount of inventory or the cost of goods sold.

B. Perpetual inventory system. Under this system the Inventory account is continuously updated. The
Inventory account is increased with the cost of merchandise purchased from suppliers and it is reduced
by the cost of merchandise that has been sold to customers. (The Purchases account(s) do not exist.)

Under the perpetual system there is a Cost of Goods Sold account that is debited at the time of each sale
for the cost of the merchandise that was sold. Under the perpetual system a sale of merchandise will
result in two journal entries: one to record the sale and the cash or accounts receivable, and one to
reduce inventory and to increase cost of goods sold.

Inventory Systems and Cost Flows Combined

The combination of the three cost flow assumptions and the two inventory systems results in six available
options when accounting for the cost of inventory and calculating the cost of goods sold:

A1. Periodic FIFO

A2. Periodic LIFO
A3. Periodic Average

B1. Perpetual FIFO

B2. Perpetual LIFO
B3. Perpetual Average

A1. Periodic FIFO

"Periodic" means that the Inventory account is not routinely updated during the accounting period.
Instead, the cost of merchandise purchased from suppliers is debited to an account called Purchases. At
the end of the accounting year the Inventory account is adjusted to equal the cost of the merchandise that
has not been sold. The cost of goods sold that will be reported on the income statement will be computed
by taking the cost of the goods purchased and subtracting the increase in inventory (or adding the
decrease in inventory).

"FIFO" is an acronym for First In, First Out. Under the FIFO cost flow assumption, the first (oldest) costs
are the first ones to leave inventory and become the cost of goods sold on the income statement. The last
(or recent) costs will be reported as inventory on the balance sheet.

Remember that the costs can flow differently than the goods. If the Corner Shelf Bookstore uses FIFO,
the owner may sell the newest book to a customer, but is allowed to report the cost of goods sold as $85
(the first, oldest cost).

Let's illustrate periodic FIFO with the amounts from the Corner Shelf Bookstore:

Number Cost Total

of Books per Cost
 Book
Inventory at Dec. 31, 2009 1 @ $85 = $ 85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 = 90
Total goods available for sale 5 $440
Less: Inventory at Dec. 31, 2010 4 - 355
Cost of goods sold 1 @ $85 $ 85

As before, we need to account for the total goods available for sale (5 books at a cost of $440). Under
FIFO we assign the first cost of $85 to the one book that was sold. The remaining $355 ($440 - $85) is
assigned to inventory. The $355 of inventory costs consists of $87 + $89 + $89 + $90. The $85 cost
assigned to the book sold is permanently gone from inventory.

If Corner Shelf Bookstore sells the textbook for $110, its gross profit under periodic FIFO will be $25
($110 - $85). If the costs of textbooks continue to increase, FIFO will always result in more profit than
other cost flows, because the first cost is always lower.

A3. Periodic Average

Under "periodic" the Inventory account is not updated and purchases of merchandise are recorded in an
account called Purchases. Under this cost flow assumption an average cost is calculated using the total
goods available for sale (cost from the beginning inventory plus the costs of all subsequent purchases
made during the entire year). In other words, the periodic average cost is calculated after the year is over
—after all the purchases of the year have occurred. This average cost is then applied to the units sold
during the year as well as to the units in inventory at the end of the year.

As you can see, our facts remain the same—there are 5 books available for sale for the year 2010 and
the cost of the goods available is $440. The weighted average cost of the books is $88 ($440 of cost of
goods available ÷ 5 books available) and it is used for both the cost of goods sold and for the cost of the
books in inventory.

Cost
Number Total
per
of Books Cost
Book
Inventory at Dec. 31, 2009 1 @ $85 = $ 85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 = 90
Total goods available for sale 5 $440
 Less: Inventory at Dec. 31, 2010 4 @ $88 - 352
Cost of goods sold 1 @ $88 $ 88

Since the bookstore sold only one book, the cost of goods sold is $88 (1 x $88). The four books still on
hand are reported at $352 (4 x $88) of cost in the Inventory account. The total of the cost of goods sold
plus the cost of the inventory should equal the total cost of goods available ($88 + $352 = $440).

If Corner Shelf Bookstore sells the textbook for $110, its gross profit under the periodic average method
will be $22 ($110 - $88). This gross profit is between the $25 computed under periodic FIFO and the $20
computed under periodic LIFO.

B1. Perpetual FIFO

Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a
retailer purchases merchandise, the retailer debits its Inventory account for the cost; when the retailer
sells the merchandise to its customers its Inventory account is credited and its Cost of Goods Sold
account is debited for the cost of the goods sold. Rather than staying dormant as it does with the periodic
method, the Inventory account balance is continuously updated.

Under the perpetual system, two transactions are recorded when merchandise is sold: (1) the sales
amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the
merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the periodic
system the second entry is not made.)

With perpetual FIFO, the first (or oldest) costs are the first moved from the Inventory account and debited
to the Cost of Goods Sold account. The end result under perpetual FIFO is the same as under periodic
FIFO. In other words, the first costs are the same whether you move the cost out of inventory with each
sale (perpetual) or whether you wait until the year is over (periodic).

B3. Perpetual Average

B3. Perpetual Average

Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a retailer
purchases merchandise, the costs are debited to its Inventory account; when the retailer sells the
merchandise to its customers the Inventory account is credited and the Cost of Goods Sold account is
debited for the cost of the goods sold. Rather than staying dormant as it does with the periodic method,
the Inventory account balance under the perpetual average is changing whenever a purchase or sale
occurs.

Under the perpetual system, two sets of entries are made whenever merchandise is sold: (1) the sales
amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the
merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the periodic
system the second entry is not made.)

Under the perpetual system, "average" means the average cost of the items in inventory as of the date of
the sale. This average cost is multiplied by the number of units sold and is removed from the Inventory
account and debited to the Cost of Goods Sold account. We use the average as of the time of the sale
because this is a perpetual method. (Note: Under the periodic system we wait until the year is over before
computing the average cost.)

Let's use the same example again for the Corner Shelf Bookstore:

Cost
Number Total
per
of Books Cost
Book
Inventory at Dec. 31, 2009 1 @ $85 = $ 85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 = 90
Total goods available for sale 5 $440.00
Less: Inventory at Dec. 31, 2010 4 @ $88.125 - 352.50
Cost of goods sold 1 @ $87.50 $ 87.50

Let's assume that after Corner Shelf makes its second purchase, Corner Shelf sells one book. This
means the average cost at the time of the sale was $87.50 ([$85 + $87 + $89 + $89] ÷ 4]). Because this is
a perpetual average, a journal entry must be made at the time of the sale for $87.50. The $87.50 (the
average cost at the time of the sale) is credited to Inventory and is debited to Cost of Goods Sold. After
the sale of one unit, three units remain in inventory and the balance in the Inventory account will be
$262.50 (3 books at an average cost of $87.50).

After Corner Shelf makes its third purchase, the average cost per unit will change to $88.125 ([$262.50 +
$90] ÷ 4). As you can see, the average cost moved from $87.50 to $88.125—this is why the perpetual
average method is sometimes referred to as the moving average method. The Inventory balance is
$352.50 (4 books with an average cost of $88.125 each).

Comparison of Cost Flow Assumptions

Below is a recap of the varying amounts for the cost of goods sold, gross profit, and ending inventory that
were calculated above.

Periodic Perpetual
FIFO LIFO Avg. FIFO LIFO Avg.
Sales $110 $110 $110 $110 $110 $110.00
Cost of Goods Sold – 85 – 90 – 88 – 85 – 89 – 87.50
Gross Profit $ 25 $ 20 $ 22 $ 25 $ 21 $ 22.50
Ending Inventory $355 $350 $352 $355 $351 $352.50
The example assumes that costs were continually increasing. The results would be different if costs were
decreasing or increasing at a slower rate. Consult with your tax advisor concerning the election of cost
flow assumption.

Methods of Estimating Inventory

There are two methods for estimating ending inventory:

1. Gross Profit Method

2. Retail Method

1. Gross Profit Method. The gross profit method for estimating inventory uses the information contained
in the top portion of a merchandiser's multiple-step income statement:

ABC Company
Income Statement (partial)
For the Year Ended Dec. 31, 2009

Sales $100,000 100.0%

Cost of Goods Sold
Beginning Inventory $ 22,000
Purchases - net 83,000
Cost of Goods Available 105,000
Less: Ending Inventory 25,000
Cost of Goods Sold 80,000 80.0%
Gross Profit $ 20,000 20.0%

Let's assume that we need to estimate the cost of inventory on hand on June 30, 2010. From the 2009
income statement shown above we can see that the company's gross profit is 20% of the sales and that
the cost of goods sold is 80% of the sales. If those percentages are reasonable for the current year, we
can use those percentages to help us estimate the cost of the inventory on hand as of June 30, 2010.

While an algebraic equation could be constructed to determine the estimated amount of ending inventory,
we prefer to simply use the income statement format. We prepare a partial income statement for the
period beginning after the date when inventory was last physically counted, and ending with the date for
which we need the estimated inventory cost. In this case, the income statement will go from January 1,
2010 until June 30, 2010.

Some of the numbers that we need are easily obtained from sales records, customers, suppliers, earlier
financial statements, etc. For example, sales for the first half of the year 2010 are taken from the
company's records. The beginning inventory amount is the ending inventory reported on the December
31, 2009 balance sheet. The purchases information for the first half of 2010 is available from the
company's records or its suppliers. The amounts that we have available are written in italics in the
following partial income statement:
 ABC Company
Income Statement (partial)
For the Six Months Ended June 30, 2010

Sales $ 56,000 100.0%

Cost of Goods Sold
Beginning Inventory $ 25,000
Purchases - net 46,000
Cost of Goods Available
Less: Ending Inventory
Cost of Goods Sold 80.0%
Gross Profit 20.0%

We will fill in the rest of the statement with the answers to the following calculations. The amounts in
italics come from the statement above. The bold amount is the answer or result of the calculation.

Step 1. Cost of Goods Available = Beginning Inventory + Net Purchases

Cost of Goods Available = $25,000 + $46,000
Cost of Goods Available = $71,000

Step 2. Gross Profit = Gross Profit Percentage (or Gross Margin) x Sales
Gross Profit = 20% x $56,000
Gross Profit = $11,200

Step 3. Cost of Goods Sold = Sales – Gross Profit

Cost of Goods Sold = $56,000 – $11,200 (from Step 2.)
Cost of Goods Sold = $44,800

This can also be calculated as 80% x Sales of $56,000 = $44,800.

Inserting this information into the income statement yields the following:

ABC Company
Income Statement (partial)
For the Six Months Ended June 30, 2010

Sales $56,000 100.0%

Cost of Goods Sold
Beginning Inventory $25,000
Purchases - net 46,000
Cost of Goods Available 71,000
Less: Ending Inventory ?
Cost of Goods Sold 44,800 80.0%
 Gross Profit $11,200 20.0%

As you can see, the ending inventory amount is not yet shown. We compute this amount by subtracting
cost of goods sold from the cost of goods available:
Ending Inventory = Cost of Goods Available – Cost of Goods Sold
Ending Inventory = $71,000 – $44,800
Ending Inventory = $26,200

Below is the completed partial income statement with the estimated amount of ending inventory at
$26,200. (Note: It is always a good idea to recheck the math on the income statement to be certain you
computed the amounts correctly.)

ABC Company
Income Statement (partial)
For the Six Months Ended June 30, 2010

Sales $56,000 100.0%

Cost of Goods Sold
Beginning Inventory $25,000
Purchases - net 46,000
Cost of Goods Available 71,000
Less: Ending Inventory 26,200
Cost of Goods Sold 44,800 80.0%
Gross Profit $11,200 20.0%

2. Retail Method. The retail method can be used by retailers who have their merchandise records in both
cost and retail selling prices. A very simple illustration for using the retail method to estimate inventory is
shown here:

Cost Retail
Beginning Inventory $ 11,000 $ 15,000
Purchases - net + 69,000 + 85,000
Goods Avail. & Cost Ratio 80,000 100,000
Less: Sales at retail - 90,000
Est. ending inventory at retail 10,000
Est. ending inventory at cost $ 8,000

As you can see, the cost amounts are arranged into one column. The retail amounts are listed in a
separate column. The Goods Available amounts are used to compute the cost-to-retail ratio. In this case
the cost of goods available of $80,000 is divided by the retail amount of goods available ($100,000). This
results in a cost-to-retail ratio, or cost ratio, of 80%.
To arrive at the estimated ending inventory at cost, we multiply the estimated ending inventory at retail
($10,000) times the cost ratio of 80% to arrive at $8,000.
.