Updated: Aug 6, 2020
Companies that are in the manufacturing and selling of physical goods industry are required to record Inventory as an ASSET in books at the time of their sale. It is generally the largest Current Assets that should be sold within one year.
Usually, manufacturing firms deal with 3 types of inventory, including
1- Raw materials (Inventory that was purchased to produce goods);
2- Working-in-Progress (Inventory that was in the process as now);
3- Finished goods (inventory that is available to be sold).
In the meanwhile, the Inventory in the retailing industry is called merchandise.
In all cases, companies try to sell Inventories to earn the profit. Before Inventory is sold, it acts as an asset of the company. When it is sold, the cost converts into an expense, called the cost of goods sold. Via Journal Entries, the cost is transferred from the Balance Sheet (asset) to Income Statement (expense).
Companies often maintain an outstanding amount of inventory to manage its operations. However, this could be hard work. Inventories need to monitor closely. Storing too much inventory could cause problems related to decreasing cash flow. Conversely, storing too little of it can make the loss of sales and customers because of the out-of-stock situation.
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Cost of Goods Sold
Cost of Goods Sold is also known as “cost of sales” or its acronym “COGS” is an important accounting term. Basically, it represents the cost of goods or merchandise that has been SOLD to customers. Unlike inventories, which are on the Balance Sheet as an asset, you can find the cost of goods sold on the Income statement as an EXPENSE. In essence, the cost of goods sold is being matched with the revenues from the goods sold. After deducting the cost of goods sold from net sales, the result is the company’s gross profit.
When the company sells out its inventory, all costs including purchasing costs, shipping costs, and all other costs are included. Direct materials, labor, and overhead cost are also involved in the cost of goods sold. For services, the cost of goods also comprises of labor, payroll, and benefit. In general, all the direct costs that are related to the production of goods and services are the costs of goods. Please note that goods that are not sold during the year would not be included in calculating COGS.
Example of Inventory and Cost of Goods Sold
Let us take an example of a retailer who just sells 1 product for the connection between Inventory and Cost of Goods Sold.
At the beginning of the year 2020, the retailer has 100 units.
During the year, the retailer purchases an additional 200 units.
The total of beginning Inventory and purchased inventory is known as goods available for sale, which is 300 units.
If the retailer has 175 units on hand at the end of the year 2020, the Balance Sheet will report the Inventory of 175 units.
That means the number of goods that were sold is 125 units and the Income statement will report the Cost of Goods Sold of 125 units that are longer available for sale.
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