Inventory and Cost of Goods Sold

A goods sale has two accounting effects: the selling price becomes revenue, and the assigned inventory cost becomes Cost of Goods Sold.

Cost flow from inventory to expense

Inventory is an asset made up of goods a business holds for sale, goods being produced for sale, and materials that will be used to produce them.

Cost of Goods Sold (COGS) is the expense representing the cost assigned to goods sold during a period. It may also be called cost of sales, although that term can be used more broadly. Until goods are sold, their cost normally remains in Inventory on the balance sheet. When they are sold, the related cost moves from Inventory to COGS on the income statement.

Components of inventory cost

Inventory cost is more than the supplier’s listed price. For a retailer, it normally begins with the purchase price, reduced by trade discounts and similar reductions, and includes acquisition, transport, and handling costs needed to bring the goods to their present location and condition. For a manufacturer, inventory cost also includes the production costs needed to turn raw materials into finished goods.

Costs that do not help bring the goods to their present location and condition are expensed instead: selling costs, general administration, storage after the goods are ready, and abnormal waste.

Effects of inventory cost allocation

Inventory cost remains an asset until the goods are sold or written down. Interchangeable units are ordinarily indistinguishable in use. When these goods have different costs, inventory accounting must also determine how much of the available cost belongs to the goods sold and how much remains in ending inventory.

Assigning too much cost to ending Inventory overstates assets and understates COGS; assigning too little has the opposite effect. Because this period’s ending inventory is next period’s opening inventory, an uncorrected error reverses through the following period’s COGS if that period’s ending inventory is measured correctly. Both periods’ profit figures are then wrong, but the second balance sheet is right. The allocation also changes gross profit:

Gross Profit  =  Sales Revenue  −  COGS

Gross profit is the amount left after subtracting the cost of the goods sold. It is not final profit: operating expenses and any other relevant income or expenses still have to be considered.

Perpetual and periodic inventory systems

A perpetual system updates the Inventory account after purchases and sales, so recorded inventory and Cost of Goods Sold (COGS) are updated through the period. Physical counts and adjustments are still needed for shrinkage, damage, and write-downs. A periodic system instead accumulates purchases separately and determines COGS at period end from the count. A simplified form is:

COGS  =  Beginning Inventory  +  Net Purchases and Included Acquisition Costs  −  Ending Inventory

The system and the cost formula answer different questions. Perpetual versus periodic determines when the records are updated. FIFO, weighted average, or specific identification determines which costs are assigned to units sold and units remaining. A business therefore does not choose “perpetual instead of FIFO”; it identifies both the recording system and the applicable cost formula.

Cost formulas

Specific identification follows the actual cost of a particular item. FIFO and weighted average instead use a cost formula to assign costs among interchangeable units. IAS 2 and ASPE Section 3031 use specific identification for non-interchangeable items and specified projects and FIFO or weighted average for other inventory of similar nature and use. Neither framework permits last-in, first-out (LIFO) as a cost formula.

• Specific identification — traces an item’s own cost when goods are not ordinarily interchangeable or are segregated for a specific project (for example, custom equipment or a particular real estate lot).
• First-in, first-out (FIFO) — assumes the oldest costs are the first expensed to COGS, leaving the most recent costs in ending inventory.
• Weighted average cost — divide the cost of units available by the number of units available. Recompute this average after each purchase in a perpetual system, or for the period in a periodic system. Apply the relevant average to units sold and units remaining.

When unit costs rise consistently, FIFO will typically assign older, lower costs to COGS and newer, higher costs to ending inventory. Compared with weighted average for the same purchases and sales, that usually produces lower COGS and higher gross profit. Actual results depend on the cost pattern and transaction sequence.

Lower of cost and net realizable value

A cost formula first determines the cost assigned to the inventory that remains. At the reporting date, that cost is then compared with the amount expected to be recovered from selling the inventory. Under IAS 2, inventory is measured at the lower of cost and net realizable value (NRV). NRV is an estimate of the selling price less the costs still needed to complete and sell the goods.

If NRV falls below cost, the inventory is written down and the difference is recognized as an expense. This measurement applies to the inventory still on hand at the reporting date; it does not revise the cost already assigned to goods sold. Under IFRS, IAS 2 requires a later increase in NRV to reverse the earlier write-down only up to the amount originally written down; the revised carrying amount still cannot exceed cost. ASPE Section 3031 reaches the same ceiling when changed economic circumstances support a reversal. Under both frameworks, the reversal reduces inventory expense in the later period rather than creating a carrying amount above cost.

Manufacturing Inventory Cost Flow

Manufacturing inventory moves through raw materials, work in progress, and finished goods. Qualifying production costs remain in inventory until the finished goods are sold or written down. The full lifecycle is explained in Manufacturing Inventory Cost Flow.

Common errors

• Treating the selling price as COGS. Revenue records what the customer is charged; COGS records the cost assigned to the goods sold.
• Assuming a cost formula must describe the physical movement of the goods. FIFO assigns costs; it does not necessarily prove which physical unit was delivered.
• Assuming a perpetual system removes the need for physical counts and adjustments for shrinkage, damage, or errors.
• Treating an NRV write-down as a change to the cost already assigned to goods sold. It adjusts the inventory that remains at the reporting date.