Quick answer
Inventory accounting divides the cost of goods available for sale between goods still on hand and goods already sold. The amount assigned to unsold goods remains an asset; the amount assigned to sold goods is recognized as Cost of Goods Sold (COGS). FIFO and weighted average are two common ways to make that assignment.
What inventory and COGS mean
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.
Inventory accounting answers two practical questions: what cost should remain in inventory, and what cost should be recognized as an expense because the goods have been sold? The answer affects both the balance sheet and reported profit.
What enters 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 acquire or produce the inventory are generally recognized as expenses instead of being added to the asset. The exact boundary depends on the applicable framework and facts, so a cost should not be included merely because it relates broadly to the business or to selling the goods.
How inventory moves through manufacturing
A retailer commonly buys completed goods and tracks them in a single Merchandise Inventory account. A manufacturer instead follows cost through three stages of production:
- Raw materials are inputs held for use in production but not yet placed into the manufacturing process.
- Work in progress (WIP) consists of goods that have entered production but are not yet complete. Its cost can include materials, direct labour, and qualifying production overhead.
- Finished goods are completed products ready for sale. Their cost remains an asset until the products are sold.
These names describe stages within inventory. As production advances, cost moves between inventory accounts without becoming an expense. It becomes COGS only when the finished product is sold.
Follow one production batch from materials to COGS
Northline Furniture buys $2,000 of wood on account. It uses $1,600 of that wood in one production batch, adds $900 of direct labour and $500 of qualifying production overhead, then completes the batch. The finished batch is sold on credit for $4,500.
| Account | Debit | Credit |
|---|---|---|
| Raw Materials Inventory | 2,000 | |
| Accounts Payable | 2,000 |
The wood is an asset held for production. No production has begun, so its cost starts in Raw Materials Inventory.
| Account | Debit | Credit |
|---|---|---|
| Work in Progress Inventory | 3,000 | |
| Raw Materials Inventory | 1,600 | |
| Wages Payable | 900 | |
| Accounts Payable | 500 |
The $3,000 debit combines materials, direct labour, and production overhead assigned to the batch. This simplified entry assumes the overhead qualifies for inclusion in inventory and is incurred on account; actual overhead recording and allocation may use additional accounts.
| Account | Debit | Credit |
|---|---|---|
| Finished Goods Inventory | 3,000 | |
| Work in Progress Inventory | 3,000 |
Completion changes the inventory’s stage, not its total cost. The $3,000 moves from WIP to Finished Goods Inventory.
| Account | Debit | Credit |
|---|---|---|
| Accounts Receivable | 4,500 | |
| Sales Revenue | 4,500 |
This entry records the amount charged to the customer.
| Account | Debit | Credit |
|---|---|---|
| Cost of Goods Sold | 3,000 | |
| Finished Goods Inventory | 3,000 |
Selling the batch ends the inventory cycle. Its $3,000 cost is now an expense and can be compared with the $4,500 of sales revenue.
Why the split matters
The manufacturing example shows when cost moves through inventory and becomes an expense. When identical or interchangeable 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 COGS is deducted from sales revenue, the allocation also changes gross profit:
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 vs. periodic 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:
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.
| Event | Perpetual system | Periodic system |
|---|---|---|
| Purchase | Updates Inventory when the purchase is recorded. | Accumulates purchases separately during the period. |
| Sale | Records revenue and the related COGS/inventory reduction. | Records the sale; COGS is not finalized with each sale. |
| Period end | Uses the physical count to verify and adjust the records. | Uses the count and cost formula to determine ending Inventory and COGS. |
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. Under IAS 2, IFRS generally uses specific identification for items that are not ordinarily interchangeable and FIFO or weighted average for other inventories; last-in, first-out (LIFO) is not permitted. ASPE requirements should be checked separately rather than assumed to match IAS 2.
- 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 — a new average unit cost is computed after each purchase (perpetual) or once at period end (periodic), and applied to both COGS and ending inventory.
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.
| Formula | COGS and gross profit | Effect on ending inventory |
|---|---|---|
| FIFO | Lower COGS, higher gross profit | More recent costs remain |
| Weighted average | Higher COGS and lower gross profit than FIFO | Blended historical cost |
Financial-statement effect
A sale affects the statements in two distinct ways. The selling price is reported as revenue, while the cost assigned to the goods sold is reported as COGS. Their difference is gross profit. Any goods that remain unsold continue to be reported as Inventory on the balance sheet.
A higher amount assigned to COGS means lower gross profit and lower ending Inventory. A lower amount assigned to COGS has the opposite effect. The cost formula changes this allocation; it does not change the selling price or the total cost available to allocate.
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. Any later reversal of a write-down must be assessed under the applicable IFRS or ASPE requirements.
Follow one retailer purchase and sale through the accounts
Compare FIFO and weighted average
The retailer has 80 opening units at $10 and buys 100 more at $12, for 180 units costing $2,000 in total. It then sells 120 units for $2,400. Holding the facts constant shows that the cost formula changes the split between COGS and the 60 units that remain—it does not change the selling price or the total $2,000 cost available for allocation.
| Formula | Calculation | COGS | Ending inventory | Gross profit |
|---|---|---|---|---|
| FIFO | 80 × $10, then 40 × $12 | $1,280.00 | $720.00 | $1,120.00 |
| Weighted average | $2,000 ÷ 180 = $11.1111 per unit | $1,333.33 | $666.67 | $1,066.67 |
Under these rising costs, FIFO assigns the older $10 units to COGS first, so it reports lower COGS and higher ending inventory than weighted average. The weighted-average amounts include rounding; COGS plus ending inventory still equals the same $2,000 cost pool.
Assign the cost of the sale using FIFO
| Layer consumed | Units | Unit cost | COGS |
|---|---|---|---|
| Opening layer | 80 | 10 | 800 |
| Next layer | 40 | 12 | 480 |
| Total COGS | 1,280 |
The remaining inventory is 60 units at $12, or $720. FIFO leaves this most recent cost layer on the balance sheet.
From purchase to sale — perpetual system
A perpetual system records the purchase as inventory immediately. The later sale requires two entries: one for the amount charged to the customer and another for the cost leaving inventory.
| Account | Debit | Credit |
|---|---|---|
| Inventory | 1,200 | |
| Accounts Payable | 1,200 |
The purchase creates an asset because these goods remain available for a future sale; it does not create COGS yet.
| Account | Debit | Credit |
|---|---|---|
| Accounts Receivable | 2,400 | |
| Sales Revenue | 2,400 |
This entry records the selling price and the related revenue.
| Account | Debit | Credit |
|---|---|---|
| Cost of Goods Sold | 1,280 | |
| Inventory | 1,280 |
This separate entry moves the FIFO cost of the 120 units from the balance sheet to the income statement.
What changes under a periodic system?
The credit sale still records Accounts Receivable and Sales Revenue when it occurs. The difference is the cost side: the business does not record the $1,280 FIFO COGS entry at the sale date. At period end it counts the 60 units, applies the selected cost formula, and uses the resulting ending Inventory to determine COGS. The economic split is the same; the timing and organization of the bookkeeping differ.
See the financial-statement effect
The $2,400 selling price and $1,280 inventory cost measure different parts of the transaction. Their difference is $1,120 of gross profit. Ending inventory is $720; it is a separate asset amount, not another measure of profit.
Effect of the FIFO purchase and sale
| Statement | Account | Effect | Timing |
|---|---|---|---|
| Balance sheet | Inventory | Ends at $720 after $1,280 of cost leaves the asset | At the reporting date |
| Balance sheet | Accounts Receivable | Increases by the $2,400 selling price | When the sale occurs |
| Balance sheet | Accounts Payable | Increases by $1,200 for the inventory purchase | When the purchase occurs |
| Income statement | Sales Revenue and COGS | $2,400 revenue less $1,280 COGS | For the period |
| Income statement | Gross Profit | Reports $1,120 before other expenses | For the period |
Apply lower of cost and NRV at the reporting date
Assume the 60 units remaining under FIFO have an NRV of $650 at the reporting date. Because $650 is below their $720 cost, the inventory is written down by $70.
| Account | Debit | Credit |
|---|---|---|
| Inventory Write-Down Expense | 70 | |
| Inventory | 70 |
This simplified direct write-down reduces ending Inventory from $720 to $650 and reduces profit by $70. Account names and whether an allowance is used can depend on the entity’s presentation and applicable requirements.
Common mistakes
- 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.
- Applying an IFRS conclusion automatically under ASPE without checking the current Section 3031 requirements.