Inventory vs Cost of Goods Sold (COGS): Formula, Examples & Differences
- Tammy Hoang
- Jun 29, 2020
- 5 min read
Updated: 6 days ago
Inventory refers to goods a business holds for sale and is recorded as a current asset on the balance sheet. Cost of Goods Sold (COGS) is the direct cost of producing or purchasing those goods and is recorded as an expense on the income statement. Understanding the flow from inventory to COGS is essential for managing cash flow, pricing, and profitability.
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What is Inventory in Accounting?
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 of 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 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 their 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 a loss of sales and customers because of the out-of-stock situation.
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What is Cost of Goods Sold (COGS)?
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.
What’s the Difference Between Inventory and COGS?
Aspect | Inventory | Cost of Goods Sold (COGS) |
Definition | Goods a business owns and intends to sell (assets). | Direct cost of goods sold during a period (expense). |
Accounting Type | Classified as a current asset on the balance sheet. | Classified as an expense on the income statement. |
Timing | Recorded when goods are purchased/produced but unsold. | Recorded when goods are sold to customers. |
Formula Relation | Beginning Inventory + Purchases – Ending Inventory. | Beginning Inventory + Purchases – Ending Inventory. (Result = COGS) |
Impact | Shows the value of unsold stock. | Reduces gross profit and net income. |
Example | 500 units in warehouse = Inventory. | 200 units sold → cost recorded as COGS. |
How Do You Calculate COGS?
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.
Why Is Understanding Inventory vs COGS Important for Businesses?
Accurately tracking Inventory and Cost of Goods Sold (COGS) is crucial for any business because these two figures directly impact financial health, tax obligations, and decision-making. Here’s why:
Ensure Accurate Financial Statements
Inventory is recorded as an asset, while COGS is an expense. Misstating either can distort the balance sheet and income statement, leading to poor financial visibility.
Measure True Profitability
COGS directly reduces gross profit and net income. If COGS is understated, profits appear inflated; if overstated, the company may look less profitable than it actually is.
Improve Cash Flow Management
Tracking inventory helps businesses avoid tying up too much cash in unsold stock. At the same time, monitoring COGS ensures that product pricing covers all costs.
Support Better Business Decisions
Clear insights into inventory turnover and cost structures allow businesses to:
Set competitive selling prices.
Negotiate better with suppliers.
Identify products with higher or lower margins.
Stay Compliant with Tax & Accounting Standards
IRS and GAAP require businesses to calculate inventory and COGS correctly. Errors can result in audits, penalties, or incorrect tax filings.
Example:
A small retail store reported $100,000 in sales for the year. However, they failed to record $20,000 of ending inventory, which inflated their COGS.
Reported COGS = $80,000
Actual COGS = $60,000
This error reduced gross profit from $40,000 to $20,000, making the business appear far less profitable than it truly was. Such mistakes can affect investor confidence, loan applications, and even tax liabilities.
Expert Solutions from Irvine Bookkeeping
At Irvine Bookkeeping, we understand the complexities of managing inventory and calculating Cost of Goods Sold (COGS) can be overwhelming for businesses. These are critical areas that directly affect your profitability and financial health. Our team of specialists is equipped to offer comprehensive bookkeeping, accounting, and tax services tailored to address these challenges. Whether it's optimizing your inventory management to improve cash flow or accurately reporting COGS for tax purposes, we're here to provide expert advice and solutions. Let us help you streamline your financial operations, so you can focus on growing your business.
If you need advice or services on any aspect of bookkeeping, accounting, and tax, our specialists are ready to help. Get in touch with us for a free quote.
About the Author
Irvine Bookkeeping Inc
Irvine Bookkeeping Inc is a U.S.-based accounting firm with over a decade of experience helping law firms manage their finances with accuracy and compliance. We specialize in legal bookkeeping, payroll, trust account reconciliation, tax compliance, and financial reporting, allowing attorneys to stay compliant, make informed decisions, and focus on serving clients while we ensure their books stay accurate and audit-ready.