Inventory Accounting Introduction

Inventory Definition

Inventory items are products or goods held for resale in the normal course of business. Inventory items can be manufactured by the company or purchased for resale. Inventory therefore consists of both finished goods ready for sale, or items in production (work in progress or raw materials).

When a company manufactures or purchases product for resell, the company first records the item as an inventory item on the balance sheet. When the company sells the item, it moves into a special line item on the income statement called cost of goods sold.

Cost of goods sold is a special item on the income statement reserved for inventory costs.

The following formula is used to determine the COGS amount for the period:

Inventory Accounting Costs: Cost of Goods Sold

Beginning Inventory + Purchases – Ending Inventory = COGS

Inventory Accounting Systems

Under the perpetual inventory system, the inventory balance is increased (debited) when the company purchases products. When products are sold, the amount is recorded directly into cost of goods sold and the inventory account is reduced (credited).

When a company uses periodic inventory reporting, inventory is recorded in the purchases account, and a physical inventory count must be taken at year-end to determine ending inventory and cost of goods sold.

Taking a Physical Inventory Count

Even when a company uses the perpetual inventory system to get a more accurate measure of inventory throughout the year, a physical inventory count should be taken in order to get the most accurate cost of goods sold figure. A physical inventory count may turn up items that are missing, broken, damaged, stolen, or simply reveal data entry errors made during the year. A physical inventory count flows to cost of goods sold to give the most accurate picture of the gross profit margin and the bottom line on the profit and loss statement.

Inventory Accounting: Lower of Cost or Market (LCM)

Inventory items are especially subject to lost value due to damage, spoilage, obsolescence, or lower demand resulting in discounted items. GAAP requires an annual test to adjust the balance to the lower of cost or market, or LCM. The test is required so that losses on inventory are matched with earnings for the same period. This prevents the reporting of inflated earnings for the same period discounted inventory items are sold.

At year end, remaining inventory items are measured at the lower of cost or market, or LCM. This means that any items remaining are compared to the current replacement value. If the current replacement value is less than the historical cost, the items are adjusted down to the replacement cost, or market, to account for the lost value. If the current replacement cost is greater than the historical cost, the items remain at historical cost.

Inventory Accounting Cost Flow Assumptions

For companies with large inventory transactions, it is neither cost-effective nor practical to track the actual cost of every inventory item. Instead, organizations may use various cost flow assumptions to simplify inventory accounting. The four main cost flow assumptions are First in First out (FIFO), Last in First Out (LIFO), Average Cost, and Specific Identification.

Four Common Cost Flow Assumptions:


  1. FIFO, or First in First Out
  2. LIFO, or Last in First Out
  3. Average Cost
  4. Specific Identification

Cost flow assumptions are used to simplify reporting cost of goods sold and inventory accounting by applying the cost flow assumptions (e.g. FIFO or LIFO) to a few data points: Available beginning inventory, purchases, and ending inventory. Click on the above links for a more detailed discussion of cost flow assumptions.

Inventory Accounting: Retailer Inventory Costs

For a retailer, the direct costs of inventory includes purchasing the product plus any additional costs necessary to get the product ready for resell, such as sales tax and shipping costs. Since gross profit is the difference between the selling price of a product and its purchase price (COGS), maintaining low cost of goods sold in comparison to the selling price is an early core measure of business strength.

Retailer Inventory Costs

Recall that Sunny had purchased sunglasses for $15 and resold them for $50 for a healthy gross profit of $35. This represents a healthy profit margin of 70%, because of the low cost of goods sold of $15 in comparison to the selling price: (50-15)/50 = 70%.

The $15 also represents what Sunny paid for inventory on the balance sheet, including all direct costs such as shipping and sales tax.

Inventory Accounting: Manufacturing Inventory Costs

For a company that manufacturers its own product, direct costs include direct material costs such as raw materials, direct labor costs such as wages of staff producing the product, and manufacturing overhead. Manufacturing overhead are those expenses incurred in producing the product but not directly linked to direct materials or direct labor. Examples of manufacturing overhead include electricity for machinery, materials to maintain machinery, and the salary of factory supervisors.

Manufacturers Inventory Costs

  • Direct Materials
  • Direct Labor
  • Manufacturing Overhead

Inventory Accounting: Monitoring Inventory Levels

Monitoring inventory levels is important to both meet demand and maximize sales while preventing too much inventory that can tie up cash and risk inventory obsolescence, write-downs, and price reductions that lead to lower profit margins. Inventory turnover is used to monitor adequate inventory levels.

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